How to calculate mutual fund sortino ratio?

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Selecting the right mutual fund that aligns with your financial goals and risk tolerance can often feel challenging, especially when there are so many choices. Thankfully, financial metrics like the Sortino Ratio are to the rescue, offering clarity and direction to investors.

Let’s take a closer look at understanding the role of sortino ratio in the context of mutual funds.

What is the Sortino ratio?

Named after its creator – Dr. Frank A. Sortino – the Sortino ratio is a statistical tool that measures the performance of an investment relative to its downward volatility or negative returns. Unlike other metrics that assess the overall volatility, the Sortino Ratio specifically focuses on the undesirable/negative volatility to assess the risk of significant losses.

Thus, the Sortino ratio provides a more nuanced view for investors who are particularly concerned about the downside risks of a potential investment avenue. Additionally, studies have found that investors are generally more concerned about losses than they are about equivalent gains. A drop in an investment's value can be distressing, particularly if the decline is sharp and significant.

While other metrics might penalise an investment for having large swings in both directions (up as well as down), the Sortino ratio gives investors a clearer picture of what kind of negative swings they can expect.

Difference between Sortino ratio and Sharpe ratio

Both the Sortino and Sharpe Ratios are used to assess risk-adjusted performance, but they differ in their approach to risk.

While the Sortino Ratio focuses only on downside deviation, the Sharpe Ratio considers the total volatility (both upside and downside). Therefore, while the Sharpe Ratio might penalise funds even for positive volatility, the Sortino Ratio does not.

Components of the Sortino ratio

• Expected return: This represents the average return that an investor might expect from a fund over a specific period.
• Target return: Sometimes referred to as the minimum acceptable return, this is a benchmark or desired return set by the investor. It could be a fixed number or even zero, depending on the context.
• Downside deviation: This is the core of the Sortino Ratio. It calculates the volatility or variation of negative returns from the target return. In essence, it provides a measure of the potential downside risk an investor is exposed to.

How to calculate the Sortino ratio?

The Sortino ratio calculation is based on three primary components mentioned above: the expected return, the target return, and the downside deviation (which is the measure of the volatility of negative returns).

Sortino Ratio = (Expected Return − Target Return) / Downside Deviation

Let’s consider an example:

Imagine you have a mutual fund that has an expected annual return of 10%. You set a target return of 4%. Let's say the downside deviation, which represents the volatility of the negative returns, is 5%.

Using the formula:

Sortino Ratio = (10 − 4) / 5 = 1.2

Understanding the significance of the Sortino ratio

A higher Sortino ratio indicates that the investment offers a better risk-adjusted return potential with respect to its downside risk. It means that, for every unit of risk taken, the investment is generating a higher amount of excess return.

A lower Sortino ratio suggests that the investment might not be compensating the investor adequately for the downside risk taken.

The Sortino ratio is a valuable tool for investors who want to evaluate the potential downside of their investments. It offers a more targeted approach to risk assessment, ensuring that investors have a clearer understanding of the possible negative outcomes.

The focus on negative volatility makes the Sortino ratio especially relevant in scenarios where the potential for loss is a significant concern. For example, if two funds have similar returns, but one has a higher Sortino Ratio, it suggests that the latter has a better risk-adjusted performance.

Some limitations of the Sortino ratio

While the Sortino ratio is an invaluable tool, it is not without its limitations:

• Focus on downside deviation: Because the ratio only considers negative volatility, it might not give a complete picture of an investment's overall risk.
• Target return assumptions: The target return is subjective. Different investors might have varied expectations, which can lead to differing Sortino Ratios for the same investment.
• Period dependency: The Sortino Ratio can vary based on the time frame considered, making it difficult to make comparisons across different periods.

Conclusion

Choosing a mutual fund that aligns with your goals and risk tolerance is not easy or straightforward, but tools like the Sortino Ratio can simplify the decision-making process. By understanding the Sortino Ratio formula and its calculation, investors can make informed choices, balancing potential returns with downside risks. However, it is essential to consider the metric along with other indicators and within the broader investment context to make a sound decision.

FAQs:

What is the significance of the Sortino ratio for mutual fund investors?
The Sortino ratio is important because it assesses a fund's risk-adjusted returns, focusing on downside volatility, which is crucial for investors concerned about market ups and downs.

How should investors interpret a mutual fund's Sortino ratio?
A higher Sortino ratio indicates that the fund is delivering returns relative to its downside risk. It's advisable to compare it with benchmarks for context.

Are there any limitations to using the Sortino ratio for investment decisions?
Sortino ratio only considers downside risk, excluding the upside potential, which might not provide a complete view of a fund's performance.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.