What Does Sortino Ratio Mean in Investments?

The Sortino Ratio is a financial metric in investment, especially in mutual funds, that helps measure the risk-adjusted return. To measure the risk-adjusted return, it focuses on the potential of a fund making a loss and penalises returns that fall below a minimum accepted level.

The Indian mutual fund industry is growing and has an AUM of ₹74.40 lakh crore, and is showing an increasing investor interest in it.

As an investor, if you are concerned with the potential of a fund making losses, learning about it might help in making informed investment decisions.      

What is Sortino Ratio in Mutual Funds?

The Sortino Ratio in a mutual fund is a statistical tool or a metric that helps depict the potential of a fund’s performance.

Unlike other ratios that might consider both upward and downward volatilities to measure a fund’s performance, this ratio only takes into account the negative movement of a fund’s return from its expected return level.

To arrive at a value, this ratio considers the historical return that an asset has generated. In this case, the average annualised return of a fund over a specified period. It takes into account the factors such as the risk-free rate and the Standard Deviation of downside risks.

Placing these values in its underlying formula, you can arrive at a value of the Sortino Ratio. Here, a higher value means a fund has a lower probability of making or delivering bad or below-target returns. Conversely, if you see this ratio higher in a mutual fund scheme, the same has a higher probability of making below-target returns.

However, if you are estimating the potential of a fund making below-target return, using this ratio in isolation might not be effective. This metric acts better as a comparative tool. By comparing the ratios of two or more funds, you can choose one with a higher ratio.

Applicable Formula to Derive the Sortino Ratio in a Mutual Fund

Understanding the Sortino Ratio meaning gives you an overview of how you can judge the potential of a fund to make bad returns. However, to actually arrive at one, you must understand how fund houses calculate this ratio.

As you have already seen, it uses a specific Sortino Ratio formula to arrive at a score or value. Here is a detailed view of it:

Sortino Ratio = (Average historical return of the fund (Rp) – Risk Free Rate) / Standard Deviation of Downside Risk (σd).

Here, the Rp represented the return a fund generated historically over a specified period in the past. It is usually its annualised returns. For example, a fund generating 14% annualised return over the 3 years, and you place this percentage in place of Rp.

The risk-free rate means the profit you might make with potentially no risks. It is often calculated using the yield of fixed-income securities such as government bonds, treasury bills, etc.

The Standard Deviation (SD) or ‘σd’ considers negative returns of a fund. Thus, it replaces positive values across the historical return with 0.

How to Calculate Sortino Ratio?

As you have noted, to arrive at the prevailing Sortino Ratio of a fund, you must have a look at its calculation and how you can use it to compare funds.

For this, let us resort to a hypothetical example. Suppose you have located two funds, namely Fund A and Fund B.

Fund A has provided an 18% annualised return with a downside deviation of 10%. While Fund B has a historical average annualised return of 20% with a downside deviation of 8%. For both the funds, assume that the risk-free rate is currently at 5%.

Sortino  Ratio for Fund A = (18 -10) / 6 = 1.33

Sortino  Ratio for Fund B = (20-8) /6 = 2

From the above calculations, you can see that Fund B has a higher ratio. It highlights that it has the potential to generate a better risk-adjusted return. It means it has the potential to generate a higher return by taking risks. Fund A is potentially more prone to the risk of making losses.

When to Use Sortino Ratio?

You have already noted that you can use a Sortino Ratio when evaluating the return of a mutual fund in comparison to the risk of getting below-target or harmful fluctuations. However, you must note the further use cases of it and here is a detailed breakdown:

1. Comparing Funds

As an informed investor, you must compare different mutual fund options before investing, instead of straight-up investing in any fund. While comparing, use the Sortino Ratio, especially for funds whose returns are similar. Filter the funds that have a higher potential of making losses.

2. Assessing Performance

You can use it to assess a fund’s past performance. Using it, you can focus only on the bad returns or below-target returns that the fund has generated. Suppose a fund delivers 14%, –3%, and 6% over the past 3 years. Here, the ratio uses only the –3% result to calculate downside risk (σd). It does not treat the positive years as risky.

3. Portfolio Analysis

You can use the Sortino ratio to evaluate mutual fund portfolios that have uneven return patterns. For example, imagine a fund that delivers small gains but occasionally shows sharp negative dips. You can assess such downside events in a fund portfolio with this ratio.

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Advantages of Sortino Ratio

Apart from understanding the meaning of the Sortino Ratio, its calculation and its use cases, you must also note its key advantages:

1. Focus Towards Downside Risks

Using the Sortino Ratio, a mutual fund showcases only its downside risks, or simply the risk of losses associated with it. Thus, risk-averse investors who are concerned about losses instead of overall volatility get a clear picture of the chances of a fund making losses and make an informed decision.

2. Helps With Goal Alignment

For investors who are opting for a mutual fund with a particular goal, the Sortino ratio of a fund helps align their goals better. Suppose you are building a retirement corpus by investing in a mutual fund. By assessing the probability of a fund making losses using this ratio, you can choose one which is less prone to risk of losses. It is because here, safety and consistency matter more than aggressive growth.

3. More Accurate Risk-Adjusted Return

This ratio comes with the potential of providing a more accurate risk-adjusted return as it focuses only towards the downside risks, unlike traditional ratios. Thus, it provides you with a clear picture of how often your chosen mutual fund might underperform your expectations.

Disadvantages of Sortino Ratio

Apart from the above advantages, this ratio also comes with a few key disadvantages that you must be careful about:

1. Ignorance of Positive Volatility

While calculating the downside risk of a fund, a Sortino ratio ignores the positive moves of it. The ratio counts them as zero while calculating. However, if a fund appears volatile in both directions and still boasts the capability of generating higher returns, this ratio might ignore that upside potential. Thus, it might favour a stable fund with lower returns.

2. Does Not Consider Liquidity or Fund Size

Being a ratio, it only focuses on the potential of a fund making losses. Thereby, it does not consider how much liquidity there is or how big the fund is. Therefore, it might impact your investment decision. Therefore, it might impact your investment decision.

Conclusion

The Sortino ratio in investments highlights a score that shows how much a fund is prone to risks of making losses. Using an underlying formula, it determines this score and the higher the score is, the less a fund is prone to making losses. 

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FAQs on Sortino Ratio

1. What is a good Sortino Ratio for mutual funds?

A Sortino ratio of less than 1 highlights a potentially good risk-adjusted fund profile. A ratio beyond 2 or 3 implies a potentially great and excellent risk-adjusted fund, respectively.

2. What is the purpose of the Sortino Ratio?

The key purpose of a Sortino ratio is to show how much a fund is potentially prone to risk of making losses.

3. How does the Sortino Ratio apply in mutual funds?

When applied in mutual funds, this metric evaluates how a certain fund might perform based on the risks it is taking. A higher ratio is typically better due to being less prone to risks of loss-making.

4. How to read Sortino Ratio?

A beta ratio of 1 means the fund has created one unit of return beyond the respective risk-free rate for each unit of downside risk. Thus, the ratio beyond 2 or 3 denotes that the fund has the potential to generate better returns.