What is Sortino Ratio in Mutual Funds?
The Sortino ratio in mutual funds is a statistical tool that is useful to measure the performance of the fund with respect to the downward deviation. In other words, this ratio is used to determine the risk-adjusted returns of a particular investment scheme.
This ratio is a variation of the Sharpe ratio, but it considers the downside or negative return. Also, this ratio is helpful for investors to assess the risk in a better way rather than just looking at the returns to the total volatility. Since investors are more concerned about the downward volatility, the Sortino ratio gives an accurate picture of the fund’s performance after the potential risks have been adjusted.
Frank A. Sortino propounded this ratio and is considered the father of post-modern portfolio theory. The objective of this ratio was to capture the harmful volatility from the total volatility by using the downside deviation. Therefore, a higher ratio indicates less likelihood of downside deviation for the mutual fund scheme.
Importance of Sortino Ratio in Mutual Funds
The following is the importance of this ratio in mutual funds –
- This ratio can address the limitation of standard deviation and measures the potential risk in a return and risk trade-off ratio.
- It is an excellent metric for comparing mutual funds over a period of time.
- Calculating the downward variation helps to differentiate between good and bad. Also helping investors with specific goals make effective investment decisions.
- Fund managers find this ratio a helpful tool for measuring their performance. It ignores all positive variances and provides an accurate picture of returns considering the market volatility.
How To Calculate Sortino Ratio in Mutual Funds?
This ratio is calculated by finding the difference between the investment’s average return and the risk-free rate. This result is then divided by the standard deviation of negative returns. The following is the formula for the Sortino ratio –
Sortino Ratio = (R – Rf)/SD
R – Expected investment returns
Rf – Risk free rate of return
SD – Standard deviation of negative asset return
|Risk Free Rate
|(10%-6%)/4% = 1
|(15%-6%)/12 = 0.75
Typically, a higher Sortino ratio is better for mutual funds. In the above scenario, Fund A indicates it is generating more returns per unit of a given risk and has greater chances of avoiding losses.
Interpretation of Sortino Ratio
A higher Sortino ratio indicates a higher return per unit of downside risk, while a lower ratio indicates lower returns per unit of downside risk. In other words, a higher ratio results in better returns to compensate investors for the risk.
Investors, analysts, fund managers and portfolio managers use this ratio to evaluate the investment’s return for a given level of bad risk. This gives a clear picture of returns that a particular investment may generate and also helps in decision-making.
Moreover, investors who are more concerned about downward volatility can use this ratio because they know that positive fluctuation will only reap profits for them. Therefore studying the downside risk is more important than understanding the total market volatility.
Limitations of Sortino Ratio
Similar to other financial ratios used for analysis in mutual funds, this ratio is also based on historical returns, which may not be a reliable indicator for future outcomes. Also, this ratio cannot be interpreted in isolation as it may not give meaningful results.
Because this ratio only uses the downside deviation method to measure risk aspects, the shortcomings may significantly influence it. For instance, for the downside deviation, there has to be a ‘bad’ risk or observation to begin for the results to be statistically unworthy of analysis.
Lastly, investors must assess the Sortino ratio in the context of their investment horizon and risk tolerance level while managing their portfolio.
Difference Between Sortino Ratio and Sharpe Ratio
The following is the difference between Sortino ratio and Sharpe ratio –
|Downside risk in investment returns
|Volatility in investment returns
|With high volatility
|With low volatility
|(Rp – Rf)/SD of negative returns
|(Rp – Rf)/SDp
|Standard deviation of negative returns
|Standard deviation of portfolio
|Considers only downside risk
|Considers total volatility – including downside & upside risk
Frequently Asked Questions
The higher the Sortino ratio, the better it is when choosing mutual funds to invest in.
The risk-free rate of return is the return that an investment instrument offers that carries zero risk. In other words, it provides a guaranteed return. In India, the treasury bill or the government security is considered the risk-free rate.
This ratio focuses on returns given by the investment when it is likely to have downside risks. Thus, this ratio is helpful when investors are more concerned about the downside risks associated with the investment.
A Sortino ratio between 1 and 2 is considered to be ideal when choosing mutual funds to invest in. However, there are instances that the ratio may go up to 3, which is excellent. In addition, there can be a negative ratio, meaning there are no rewards for the risks taken.