What is Sortino Ratio in Mutual Fund?

When it comes to investing, understanding risk is as important as chasing returns. The Sortino Ratio is a tool that helps us measure the performance of a mutual fund while focusing on downside risks. This ratio helps you determine how well a mutual fund performs when adjusted for risks that could lead to losses. Unlike other metrics, it doesn’t punish funds for positive fluctuations, making it a favourite for many investors. This blog will explain what the Sortino Ratio is, how it works, its formula, and why it matters.  

How is the Sortino Ratio Calculated?

The Sortino Ratio helps us understand how much return an investment generates for each unit of downside risk. Calculating it is simple if you follow a few steps:

1. Know the Expected Return: This is the return you expect the mutual fund to generate over a period.
2. Find the Risk-Free Rate: This is the return you can earn from a risk-free investment, like government bonds.
3. Measure the Downside Deviation: This is the amount of negative variation in the fund’s returns.

The formula for the Sortino Ratio:

Sortino Ratio=  Expected Return – Risk-Free Rate / Downside Deviation 

Steps to Calculate

• Subtract the risk-free rate from the expected return to get the excess return.
• Divide this value by the downside deviation to find the Sortino Ratio.

Example of Sortino Ratio Calculation

Let’s go through a simple example to understand how the Sortino Ratio works. Imagine a mutual fund that has the following details:

• Expected Return: 10%
• Risk-Free Rate: 4%
• Downside Deviation: 2%

Step 1: Subtract the risk-free rate from the expected return:
10% – 4% = 6%

Step 2: Divide the result by the downside deviation:
6% ÷ 2% = 3

In this example, the Sortino Ratio is 3. This means that for every unit of downside risk, the mutual fund has generated three units of return. A ratio of 3 is considered good because it shows the fund is providing a decent return with minimal downside risk.

The higher the Sortino Ratio, the better the risk-adjusted performance of the fund. Investors often look for a high Sortino Ratio to ensure they are getting strong returns without taking on excessive risk.

Importance of Sortino Ratio

The Sortino Ratio is an important tool for investors who want to focus on the downside risk, or the possibility of losses rather than just overall risk. It provides a more accurate measure of how well an investment performs while limiting the risk of losing money. Here’s why it’s crucial:

• Focuses on Downside Risk: The Sortino Ratio measures only the risk of losses, not total risk, making it more relevant for risk-averse investors.
• Helps Avoid Large Losses: It shows how well an investment performs while minimising the chances of losing money, which is a key concern for most investors.
• Measures Risk-Adjusted Return: A higher Sortino Ratio means a fund is generating better returns with less downside risk, which is more desirable for investors.
• Useful for Comparing Investments: Investors can use the Sortino Ratio to compare different mutual funds or investment options. The fund with the higher ratio is likely a better choice, as it offers better returns for each unit of downside risk.
• Better Understanding of Performance: The ratio helps investors assess how effectively a fund is performing with minimal risk, focusing on the quality of returns rather than just the total return.
• Informed Decision Making: The Sortino Ratio provides a clearer picture of an investment’s risk-return profile, helping investors make smarter, safer choices.

Also Read: Statutory Liquidity Ratio (SLR): Objectives, Uses and Components

Limitations of Sortino Ratio

While the Sortino Ratio is helpful, it has some limitations that investors should keep in mind:

Ignores Upside Risk

It only focuses on downside risk and does not consider the potential benefits of positive fluctuations in returns.

Relies on Historical Data

The ratio is based on past performance, which may not always predict future results. Market conditions can change, affecting the ratio’s reliability.

No Standard Benchmark

The Sortino Ratio depends on the choice of the risk-free rate and downside deviation. Different investors may use different values, which can lead to varied results.

Doesn’t Measure Overall Risk

Unlike the Sharpe Ratio, it does not measure total volatility. This means it might not give a complete picture of a fund’s risk profile.

May Overlook Long-Term Risks

The Sortino Ratio focuses on short-term downside risks, which could be misleading for long-term investors who are more concerned with long-term market changes.

Difference Between Sortino Ratio and Sharpe Ratio

Both the Sortino Ratio and Sharpe Ratio are popular tools for measuring risk-adjusted returns, but they differ in the type of risk they consider. 

Conclusion 

Understanding risk is the key to successful investing. The Sortino Ratio offers a more refined approach to measuring performance by focusing solely on downside risks. While it’s a powerful tool, it’s important to use it alongside other metrics to get a complete picture. By combining these insights, you can make better decisions and choose mutual funds that align with your financial goals. Remember, the goal isn’t just to earn returns but to earn them wisely!