Understanding the Significance of Sortino Ratio in Mutual Funds

Mutual fund investors consider several metrics before purchasing units. They must analyse the fund’s performance based on different parameters before investing. While you might be aware of NAV, AUM, and return rate, there are many other essential metrics. The Sortino ratio is one of the important statistical tools to analyse the risk-free return prospects of a mutual fund scheme. Continue reading to understand what is the Sortino ratio in detail.

What is the Sortino Ratio?

You might be familiar with the Sharpe ratio used in the context of mutual funds . It denotes the risk-adjusted return for a mutual fund scheme. The Sharpe ratio considers both the upward and downward volatility to calculate the risk-adjusted return rate. The Sortino ratio is a variation of the Sharpe ratio, which does not consider upward volatility. It can help you get the risk-adjusted return rate considering the downward volatility.

Mutual fund investors aren’t much worried about the upward volatility. The upward volatility shows the upside movement in the mutual fund scheme. However, investors are concerned about the downward volatility, which might offset gains. The ratio gives a clear understanding of returns considering the downward risks of the scheme. Investors prefer mutual fund schemes in which this ratio is on the higher side, as it reduces the chances of downward deviation.

Example of How to Use the Sortino Ratio

The ratio helps you determine the returns you receive on taking risks in a mutual fund scheme. Let us say a mutual fund scheme ‘X’ has a Sortino ratio of 0.80. Another mutual fund scheme ‘Y’ has a Sortino ratio of 0.95. Since the ratio of Y is more than X, it is preferred by most investors. A higher ratio represents that Y is generating more returns per unit, considering the risk it takes.

Investors can use it to understand the money they make despite the downward volatility. Investors can use this formula to find the risk-adjusted return for a mutual fund scheme. However, you must know the average return, risk-free rate, and the standard downward deviation to calculate the Sortino ratio for a mutual fund scheme. This statistical tool can be used to make the right decision while purchasing or redeeming mutual fund units.

Importance

The Sortino ratio is an important tool for analysing the returns of a mutual fund scheme. It helps calculate the return of a mutual fund scheme considering the downward volatility. Mutual fund managers often use this ratio to calculate the risk-free return. Since it ignores all positive variances, fund managers can calculate the per unit return based on the downward volatility risk. These can help compare the performance of two or more mutual fund schemes over time.

How to Calculate Sortino Ratio in Mutual Funds?

Fund managers usually release the ratio along with other metrics in commentaries for investors. However, you can calculate it for any mutual fund scheme based on the formula. Here’s the Sortino ratio formula:

Sortino Ratio = (R – Rf) / SD

In the above formula, ‘R’ is the expected return for investing in a mutual fund scheme. ‘Rf’ in the above formula is the risk-free rate of the concerned mutual fund scheme. It is usually calculated based on a government bond or any other similar financial instrument. It is also the minimum acceptable return for the concerned mutual fund scheme. Last but not least, ‘SD’ is the standard downward deviation of the mutual fund scheme. It helps determine the volatility of downward returns for a mutual fund. It denotes the deviation of all returns falling below the minimum acceptable return or any other target level.

Interpretation of Sortino Ratio

Now that you have understood the Sortino ratio meaning, let us discuss how to interpret it. Before delving into investment analysis using these ratios, it’s crucial to comprehend the implications of different values. This ratio facilitates the comparison of two or more mutual fund schemes. A higher ratio implies that a mutual fund provides greater returns per unit of downward risk, while a lower ratio indicates fewer returns for the risk undertaken by the investor.

Recommended Read: Mutual Fund Redemption Meaning

While the ratio can span from positive to negative infinity, it generally hovers around one. Mutual fund schemes with a ratio of less than one might not yield substantial returns, whereas those exceeding one are typically preferred by investors. Investors interpret this metric to gauge returns related to downward volatility. Upward volatility’s impact on returns is usually overlooked, with a focus solely on evaluating downward volatility risk.

Limitations

Even though this metric is essential, it has some limitations. The primary limitation is that it’s based on the historical returns of a mutual fund scheme. While historical returns can aid in predicting outcomes, they are not guaranteed. There have been instances where mutual fund returns plummeted despite higher metrics. Additionally, it does not consider the upward volatility risk for a mutual fund. Unlike other ratios, it only focuses on the downward risk to calculate returns. Although upward volatility can lead to more profits for investors, concentrating solely on downward risk might overlook other essential factors. Investors should complement this metric with other statistical tools for a comprehensive assessment.

Difference Between Sortino Ratio and Sharpe Ratio

Both Sortino and Sharpe ratios help determine the risk-free return for a mutual fund. However, there are certain dissimilarities, like: 

Sortino Ratio	Sharpe Ratio
It only considers the downside risk for calculating the risk-free return.	It considers both downside and upside risks to calculate the risk-free return.
The formula is (R – Rf) / SD. Here, ‘SD’ is the standard deviation of negative returns in a mutual fund.	The formula for the Sharpe ratio is (R – Rf) / SD. Here, ‘SD’ is the standard deviation of the entire portfolio, considering both the upward and downward deviation of returns.
It is effective for mutual fund schemes having a high volatility.	It is perfect for mutual fund schemes with low volatility.
It helps determine the mutual fund returns per unit of downside risk.	It helps determine the return per unit of total portfolio risk.

In a Nutshell

The Sortino ratio is an excellent statistical tool to analyse the risk-free return for a mutual fund scheme. Since it considers only the downside risk, it gives a clear picture of the risk-adjusted return. It might work better than the Sharpe ratio for mutual fund schemes with high volatility. Beginners in the market must be aware of the Sharpe ratio, Sortino ratio, AUM , NAV, and other metrics. It will allow them to compare mutual fund schemes and make informed investments.