What is the mutual fund sortino ratio?

Despite being a popular investment choice today, mutual funds have their pros and cons. This can make it challenging for investors to assess the risk and return of various schemes. However, a metric called ‘Sortino Ratio’ can help investors out. So, what is Sortino ratio and how significant is its role in evaluating the risk-adjusted performance of mutual funds? Let’s find out!

• Table of contents

1. Understanding Sortino ratio
2. How to calculate Sortino ratio
3. Example of Sortino ratio calculation
4. Interpretation of Sortino ratio
5. Difference between Sortino ratio and Sharpe ratio
6. Importance of Sortino ratio in mutual funds
7. Limitations of Sortino ratio

Understanding Sortino ratio

The Sortino ratio is a metric of how well an investment, like a mutual fund, performs compared to the risk it takes. It helps investors understand how much return they are getting for each unit of risk that comes from potential losses.

Unlike the well-known Sharpe ratio, which considers total volatility, the Sortino ratio focuses only on negative volatility or downside risk. Downside risk refers to the risk of negative returns or losses. It focuses on how much an investment might lose when things go bad.

This may make it a more relevant measure for investors who are primarily concerned with potentially minimizing losses rather than reducing overall volatility.

The Sortino ratio can help investors understand what the risk-return balance on an investment is. A higher Sortino Ratio means the investment is better at generating returns without exposing you to too much downside risk. It's a useful tool for comparing different investments.

How to calculate the Sortino ratio in mutual funds

There are three components of the Sortino ratio formula, as follows:

1. Expected return: How much money you expect to make from your investment.

2. Risk-free rate: The return you would get if you invested in something with minimal risk, such as high-quality government bonds.

3. Downside deviation: A measure of how much the investment's returns go below a certain level, showing how much risk there is of losing money.

Sortino ratio formula

The Sortino Ratio is calculated by taking the difference between the expected return of the investment and the risk-free rate, and then dividing that by the downside risk.

Sortino ratio = Expected rate of return – Risk-free rate/Standard deviation of the downside risk

Example of Sortino ratio calculation

Let's consider two investment portfolios, Portfolio A and Portfolio B, with different annualized returns:

Portfolio A has an annualized return of 15%, while Portfolio B boasts a higher annualized return of 20%. To account for the risk-free rate, which is assumed to be 8% in this case, we need to evaluate the downside deviation of each portfolio.

Portfolio A has a downside deviation of 5%, while Portfolio B's downside deviation is 10%.

Now, applying the Sortino ratio formula to both portfolios:

• Sortino ratio for Portfolio A = (15% - 8%) / 5% = 1.4

• Sortino ratio for Portfolio B = (20% - 8%) / 10% = 1.2

Even though Portfolio B offers higher returns compared to Portfolio A, the Sortino ratio provides a different perspective. If you are an investor who places greater emphasis on mitigating downside risk, Portfolio A emerges as the more favorable choice due to its higher Sortino ratio of 1.4, indicating a better risk-adjusted performance.

Interpretation of Sortino ratio

A higher Sortino ratio reveals that the investment delivered reasonable returns with respect to individual units of downward risk. In other words, a scheme with a higher Sortino ratio generates more profits per unit of the given risk, implying that it has a greater probability of mitigating the impact of volatility. Generally, a Sortino ratio of 2 and above is considered to be good.

Read Also: What is risk-adjusted returns in Mutual Funds?

Difference between Sortino ratio and Sharpe ratio

The primary distinction between the Sortino ratio and the Sharpe ratio lies in their treatment of risk. Specifically, the Sortino ratio focuses solely on the standard deviation of downside risk, while the Sharpe ratio encompasses the total standard deviation, accounting for both upside and downside risks. While the Sharpe ratio penalizes both upside and downside volatility, the Sortino ratio penalizes only those returns falling below a specified target or rate of return. Thus, we can say that Sortino ratio is a modification of Sharpe ratio.

Risk Measures Comparison

Criteria	Sharpe ratio	Sortino ratio
Focus	Measures total risk (upside and downside volatility)	Measures only downside risk (negative returns)
Risk Measure	Standard deviation of returns	Downside deviation (returns below a certain threshold)
Purpose	To measure risk-adjusted return considering all volatility	To measure risk-adjusted return considering only negative volatility
Used for	General investment performance analysis	Analysis focused on avoiding losses
Formula	Expected return - Risk-free return / Standard deviation of investment returns	Expected return - Risk-free return / Standard Deviation of the downside

Importance of Sortino ratio in mutual funds

• Focuses Downside Risk: Unlike some other risk-adjusted measures that consider both upward and downward price fluctuations, the Sortino ratio concentrates solely on the downside risk. This aligns it with investors' primary concerns of protecting their capital from significant erosion.

• Risk Assessment: It provides investors with a more accurate picture of the risk associated with an investment. By factoring in only downside volatility, it accounts for the practical risk that truly matters to investors.

• Performance Evaluation: The Sortino ratio allows investors to evaluate the performance of mutual funds concerning the returns they generate relative to their downside risk. Thus, it helps answer the question – "Is the fund's return worth the risk?"

• Benchmarking: Investors can use the Sortino ratio along with other metrics to compare the risk-adjusted performance of different mutual funds, helping them choose the fund that aligns with their risk tolerance and financial goals.

Limitations of Sortino ratio

Similar to other ratios used to analyze mutual funds, the Sortino ratio relies on historical returns, making it an imperfect predictor of future outcomes. Furthermore, interpreting the Sortino ratio in isolation may yield incomplete insights.

Moreover, since the Sortino ratio places significant emphasis on the downside deviation method for risk evaluation, its reliability can be affected by inherent limitations. Specifically, the presence of unfavorable data points is essential for meaningful analysis when using downside deviation.

Additionally, when investors utilize the Sortino ratio to manage their portfolios, it's crucial to contextualize it. This involves considering their unique risk tolerance levels and investment horizons, which should be factored in while assessing the Sortino ratio.

Conclusion

The Sortino ratio is a useful tool for mutual fund analysis, offering a focused and insightful perspective on risk-adjusted performance. By emphasising downside risk and aligning it with the investor's expected rate of return or a benchmark, the Sortino ratio can help individuals make more informed investment decisions. However, it's essential to remember that no single metric provides a complete picture of an investment's potential. Therefore, the Sortino ratio should be used in conjunction with other performance and risk metrics for a more comprehensive evaluation of an investment option. Additionally, investors should carefully consider their own financial goals, risk tolerance, and time horizon when interpreting and applying the Sortino ratio.

FAQs:

What does a high sortino ratio indicate for a mutual fund?
A high Sortino Ratio suggests that the mutual fund has generated reasonable returns relative to the downside risk it has taken. It implies that the fund manager has effectively managed risk, making it a preferred investment option for those seeking a balance between returns and risk.

Can the sortino ratio be used in isolation to evaluate a mutual fund's performance?
No, the sortino ratio should be used in conjunction with other performance measures. While it focuses on downside risk, it doesn't provide a comprehensive view of a fund's overall performance. Investors should consider multiple metrics, such as the sharpe ratio and the fund's investment strategy.

When can you use the Sortino Ratio?
The Sortino Ratio can be used to compare two or more mutual fund schemes. The Sortino ratio can give you an idea of the risk-adjusted returns – how much return you may get per unit of downside risk taken. So, two mutual fund schemes may have the same expected or historical rate of return, but one way entail more risk than the other (reflected in a lower Sortino ratio). This can be particularly useful for who are more concerned with trying to mitigate losses than earning potential returns or reducing portfolio volatility.

What is considered to be an ideal Sortino ratio?
A Sortino ratio of 1.0 and above indicates that the investment has been typically generating more return than the downside risk it is taking on. However, what constitutes a good Sortino ratio can vary depending on the context and the specific investment.

• Above 1.0: The investment is generating more return per unit of downside risk.
• Above 2.0: Considered very good, indicating the investment is providing high returns for relatively low downside risk.
• Above 3.0: Exceptional, suggesting the investment is performing extremely well in terms of risk-adjusted returns. It's important to compare the Sortino Ratio within the context of similar investments or benchmarks to get a clearer understanding

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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