Sortino Ratio: How can it help conservative investors pick mutual funds
If you are concerned more about market downsides rather than volatility in general, Sortino ratio can help you
There are many mutual fund ratios that investors can use to assess mutual funds before they invest in them. This includes Beta, Sharpe ratio, R-Squared, Alpha, and so on. Read this article for more information on these ratios – The mutual funds ratios you need to know. The Sortino ratio is one of the ratios that investors can use.
Sortino ratio was named after Frank A. Sortino who was the professor of the U.S. Pension Research Institute. Sortino ratio is most often used by conservative investors. While it provides risk adjusted returns, it differentiates harmful volatility from total overall volatility of the fund.
Sortino ratio uses the fund’s standard deviation of negative portfolio returns. This means that it considers only the downside deviation instead of the total standard deviation of the fund’s returns. So, the Sortino ratio is a useful way for investors to evaluate a fund’s return for a given level of bad risk. The reason why many investors choose the Sortino ratio over Sharpe ratio is that it uses only the downside deviation as its risk measure for calculating risk adjusted returns. There is little need to use total risk or standard deviation because upside volatility of the fund is beneficial to investors and it is not a factor to consider for risk averse investors.
How is Sortino ratio calculated?
The Sortino ratio takes the fund’s portfolio return and subtracts the risk-free interest rate from it. Then, it divides that amount by the fund’s downside deviation. In simple words, the ratio will tell investors if the fund manager has been able to cap the downside to the fund’s portfolio.
Just like the Sharpe ratio, a higher Sortino ratio is better than a lower one. A higher Sortino ratio means there is less probability of downturns in the mutual fund scheme.
When looking at two funds, an investor should choose one with the higher Sortino ratio. This is because a higher Sortino ratio means that the fund is earning more returns for every unit of the bad risk that it takes on.
Sortino Ratio = AR – RF/ Downside deviation, where AR is the annualised return; RF is the risk-free rate of return. For instance, let’s say Mutual Fund A has an annualized return of 14% and a downside deviation of 11%. Mutual Fund B has an annualized return of 12% and a downside deviation of 7.5%. We are assuming the risk-free rate is 4%. The Sortino ratios for fund A and fund B will be calculated as:
Sortino ratio for Mutual Fund A = 14% -4% / 11% = 0.90
Sortino ratio for Mutual Fund B = 12% – 4% / 7.5% = 1.07
Looking only at the fund returns, mutual fund A might seem a good choice as it provides 2% more than mutual fund B. However, even though fund B is providing more on an annualized basis, it is not earning that return as efficiently as fund B. This is after considering their downside deviations. Based on the Sortino ratio of the funds, an investor will decide to choose fund B over fund A.
Note that most of the time risk-free rate of return is used to calculate Sortino ratio, investors can also use expected return for calculating the ratio.
Difference between Sortino and Sharpe ratio
The Sortino ratio isolates the downside volatility from the total volatility. Sharpe ratio considers the good risks as bad risks, even though they provide positive returns for investors. Those investors who want to consider all risks irrespective of the outcomes may use Sharpe ratio. However, since Sortino ratio gives more importance to the downside of the investment, it might be preferred by conservative investors.
Points to note
Sortino ratio is based on historical returns and cannot be interpreted in isolation. You need to assess it in comparison with another comparable fund. It is good to use it in the context of the fund’s investment time horizon and your risk profile.
Therefore, Sortino ratio is best suited for conservative or risk-averse investors who are concerned about downturns. It provides a better view of the fund’s risk-adjusted performance because it takes the positive volatility as an advantage for the fund.