Sortino ratio is a valuable tool used by investors, analysts, and portfolio managers to assess the return of an investment relative to its downside risk. Several investors and analysts use this ratio to determine how well an investment or portfolio performs after adjusting for risk. It is similar to the Sharpe Ratio but focuses specifically on the downside risk. Through this article, let’s understand the meaning of the Sortino ratio in mutual funds, learn its calculation in simple steps, and observe how investors use it to compare the performance of different mutual fund schemes.
What is Sortino ratio?
The Sortino ratio measures an investment's risk-adjusted return by focusing specifically on downside risk. It shows how well an investment has performed after considering the downside deviation.
Unlike the Sharpe ratio, which considers total volatility, the Sortino ratio emphasises the volatility of returns below
- A defined target
or - Minimum acceptable return
Hence, it is particularly useful for evaluating investments where downside risk is a primary concern, such as for risk-averse investors or in strategies where avoiding losses is paramount.
What is the Sortino ratio in mutual fund?
We can apply the Sortino ratio to mutual funds just like any other investment. It helps investors assess how well a fund has performed relative to a specific target return or minimum acceptable return (MAR). While doing such an assessment, the Sortino ratio considers the volatility of returns below that target. A higher Sortino ratio suggests that the fund has delivered better risk-adjusted returns.
Example of how to use Sortino ratio in mutual funds
Let’s consider a hypothetical example involving an investor, Mrs A who is considering two mutual fund schemes - Fund A and Fund B
- Mrs A has a minimum acceptable return (MAR) of 8% per year
- She wants to assess which fund offers better risk-adjusted returns using the Sortino ratio
- Assume that the funds have delivered these returns over the past three years:
Mutual funds |
Year 1 |
Year 2 |
Year 3 |
Fund A |
12% |
7% |
9% |
Fund B |
10% |
9% |
11% |
- Now, let's calculate the figures required for calculating the Sortino ratio for both funds using Mrs A's MAR of 8%.
Mutual funds |
Year 1 |
Year 2 |
Year 3 |
Average return |
Total downside deviation () |
Fund A’s downside deviation |
No downside (12% > 8%) |
Downside deviation = 7% - 8% = -1% |
No downside (9% > 8%) |
(12% + 7% + 9%) / 3 = 9.33% |
(1%)2 / 3 = 0.33% |
Fund B |
8% - 10% = -2% |
No downside (9% > 8%) |
No downside (11% > 8%) |
(10% + 9% + 11%) / 3 = 10% |
(2%)2/3 = 0.67% |
- Finally, now Mrs A will calculate the Sortino ratio by putting the above figures in to the Sortino ratio formula:
- Fund A: (9.33% - 8%) / 0.33% = 4.03 ≈ 4
- Fund B: (10% - 8%) / 0.67% = 2.98 ≈ 3
- Based on these calculations, Mrs A interprets that:
- Fund A has a higher Sortino ratio in comparison to Fund B
- This indicates Fund A gives better risk-adjusted returns relative to Fund B.
- Also, Fund A is more adept at managing downside risk compared to Fund B
Importance of Sortino ratio in mutual funds
The Sortino ratio is crucial in evaluating mutual funds because it specifically highlights how well a fund manages downside risk. Mutual fund investors, particularly those seeking to minimise losses, benefit from it.
Unlike the Sharpe ratio, which considers “all” volatility, the Sortino ratio emphasises the volatility of negative returns. For risk-averse investors or those with specific downside risk tolerance, such as retirees or conservative investors, the Sortino ratio provides a clearer picture of how well a mutual fund preserves capital during unfavourable market conditions.
Formula of Sortino ratio
To begin with, let’s first learn the Sortino ratio formula:
Sortino Ratio = (Rp – MAR) / σd |
Where,
- Rp = Average return of the investment or portfolio (in the case of mutual funds “σd” represents the average return of the mutual fund scheme you are considering)
- MAR = Minimum acceptable return
- σd = Downside deviation (volatility of returns below MAR)
How to calculate Sortino ratio in mutual funds?
Let’s understand the calculation process through easy steps:
Step I: Determine the average return
- Calculate the average return of the mutual fund scheme over a specific period, say 3 years or 5 years
- Simply take the mean of the returns for each period.
Step II: Set the Minimum Acceptable Return (MAR)
- Determine the minimum acceptable return (MAR)
- It represents your target return or the threshold for acceptable performance
- MAR is based on your:
- Risk tolerance
and - Investment objectives
- Risk tolerance
Step III: Calculate the downside deviation (Volatility of returns below MAR)
- Identify periods where the return is below the MAR
- For each identified period, calculate the deviation from the MAR
- Square these deviations and sum them up
- Then, divide the result obtained by the number of periods
- Finally, take the square root to get the downside deviation
Step IV: Compute the Sortino ratio
- Now you have obtained all the required figures
- Just put these figures in the formula mentioned above to calculate the Sortino ratio
Interpretation of Sortino ratio
As per a general rule of thumb, a higher Sortino ratio indicates better risk-adjusted returns. It suggests that the mutual fund has achieved better performance, considering the risk of losses.
On the other hand, a lower Sortino ratio indicates poorer risk-adjusted returns.
When to use Sortino ratio?
The Sortino ratio is most useful when evaluating investments where minimising downside risk is paramount, such as in:
- Conservative mutual fund portfolios
- Retirement funds, or
- Strategies focused on capital preservation
It's particularly valuable when comparing assets or funds with similar returns but differing risk profiles. That’s because it specifically accounts for downside volatility.
Hence, investors concerned about preserving capital or experiencing negative returns can rely on the Sortino ratio to better understand an investment's risk-adjusted performance.
Limitations of Sortino ratio
Several investors and analysts prefer using the Sortino ratio to determine the comparative performance of different mutual fund schemes. However, this ratio also has certain limitations you must be aware of:
High dependence on MAR
- The Sortino ratio is sensitive to the choice of the Minimum Acceptable Return (MAR).
- Different investors have different MARs based on their:
- Risk tolerance
and - Investment objectives
- Risk tolerance
- Therefore, comparing Sortino ratios across different funds will not be meaningful if they use different MARs.
Focuses only on downside risk
- The Sortino ratio only considers downside risk
- It completely neglects the upside volatility
- As a result, the Sortino ratio overlooks funds that have achieved high returns with high volatility
Does not account for fund size or liquidity
- The Sortino ratio does not consider factors such as:
- Size of the fund
or - Its liquidity
- Size of the fund
- It is a proven fact that these factors significantly affect the risk and return characteristics of mutual funds
Does not consider portfolio diversification
- The Sortino ratio evaluates individual funds in isolation
- It does not account for the benefits of portfolio diversification
- A fund with a lower Sortino ratio may still add value to a diversified portfolio by reducing overall portfolio risk
Conclusion
The Sortino ratio is a popular tool widely used by mutual fund investors to calculate risk-adjusted returns. Usually, a higher Sortino ratio indicates that the fund has delivered a better performance. However, its usage is limited by its dependence on the chosen Minimum Acceptable Return (MAR) and neglect of upside volatility. Additionally, it also overlooks factors like fund size, liquidity, and portfolio diversification.
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