What is the mutual fund sortino ratio?

sortino ratio in mutual fund
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Despite being a popular investment choice today, mutual funds have their own 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’ has been introduced to 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 sortino ratio is calculated:
  3. Example of sortino ratio calculation
  4. How to interpret the sortino ratio
  5. Sortino ratio vs sharpe ratio
  6. Importance of sortino ratio in mutual funds
  7. Limitations of the sortino ratio
  8. FAQ

Understanding Sortino Ratio

Sortino ratio is a metric used to assess the risk-adjusted performance of an investment – particularly mutual funds – by taking into account the downside risk. Unlike the well-known Sharpe ratio, which considers total volatility, the Sortino ratio focuses only on the negative volatility or downside risk.

SR = (Rp – Rf) / SD

In this formula:

  • Rp refers to the expected returns from investments
  • Rf indicates the risk-free rate of return
  • SD denotes the standard deviation of downside

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.

How to Interpret the 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. As a thumb rule, any Sortino ratio of 2 and above is considered to be ideal.

Sortino Ratio vs 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.

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 the 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.

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.