Sortino Ratio in Mutual Funds: Definition, Formula and Calculation

How do you compare a fund manager who generates 18% with 50% standard deviation versus another fund manager who generates 16% returns with 15% standard deviation? Even intuitively, you can say that the first fund manager is just taking on too much risk to earn that excess return of 2%. Sharpe reduces your cost by focusing on risk adjusted returns than on pure returns. The numerator represents the fund’s excess returns as calculated on a monthly basis, measured as the difference between the actual portfolio return and the expected return. This is what the fund is earning over and above what the investor should be ideally earning.

which ratio uses downside deviation

Roy’s ratio can also be related to the Sortino ratio, which also makes use of MAR within the numerator, but makes use of a unique normal deviation (semi/downside deviation) within the denominator. Sharpe Ratio is a commonly used measure to compare risk-adjusted returns of two or more funds within a category. This ratio shows how much return an investor is earning in correlation to the level of risk being undertaken.

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  • The major difference between the Sortino ratio and the Sharpe ratio is that the Sortino ratio assumes only the downside volatility as it divides excess returns by downside volatility instead of total volatility.
  • To calculate the Sharpe ratio, you first calculate the expected return on an funding portfolio or particular person stock and then subtract the risk-free fee of return.
  • He is extremely passionate about Equity markets and swears by the age-old maxim of “Time in the market is more important than timing the market”.
  • Frank A. Sortino propounded this ratio and is considered the father of post-modern portfolio theory.
  • The idea is that mutual funds should compensate investors by efficiently managing the assets in the portfolio to generate a risk premium because systemic risk cannot be mitigated by diversification.

When there is a choice between two or more funds, it is always better to pick the one which has the highest sharpe ratio since it signifies the maximum return as compared to the risk involved. The Sortino ratio is similar to the Sharpe ratio, except it uses downside deviation for the denominator instead of Standard Deviation . Standard deviation involves both the upward as well as the downward volatility.

What is Sortino Ratio?

An investor should look for an investment where the Sharpe ratio is greater than 1. A higher Sharpe ratio offers a better risk-return scenario for an investor. If the Sharpe ratio is negative, it means that either the risk-free rate is higher than the returns of the portfolio, or the portfolio’s return could be negative.

In choosing between the two, risk-tolerant investors may find Tata Equity Opportunity more appealing, while those who are more risk-averse may be willing to give up some gains for a smoother ride with L&T Growth. Like the other metrics we’ve discussed during the past several weeks, the ratio is based on historical returns, which are not a reliable indicator of future outcomes . And as previously mentioned, a fund’s Sortino ratio needs to be viewed in comparison with another fund, index, or category because it is not meaningful when viewed in isolation. As useful as the Sortino ratio can be, investors need to keep in mind some caveats when using it.

which ratio uses downside deviation

If two funds supply comparable returns, the one with larger standard deviation could have a lower Sharpe ratio. In order to compensate for the higher normal deviation, the fund must generate the next return to keep up a better Sharpe ratio. Portfolio diversification with assets having low to unfavorable correlation tends to cut back the general portfolio risk and consequently will increase the Sharpe ratio. For instance, let’s take a portfolio that comprises 50 per cent fairness and 50 per cent bonds with a portfolio return of 20 per cent and a regular deviation of 10 per cent. Let’s add one other asset class to the portfolio, particularly a hedge fund, and tweak the portfolio allocation to 50 per cent in equity, forty per cent in bonds and 10 per cent within the hedge fund.

Also, this ratio is helpful for investors to assess the risk in a better way rather than just looking at the returns to the total volatility. Since investors are more concerned about the downward volatility, the Sortino ratio gives an accurate picture of the fund’s performance after the potential risks have been adjusted. However, figuring out which ratio to make use of is determined by whether the investor wants to give attention to complete or commonplace deviation, or just draw back deviation.

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In this way, beta can impression a inventory’s expected price of return and share valuation. Investors typically use this figure to measure the risk and performance of investments in a portfolio like mutual funds. Since it tells the excess returns above the investors’ minimum acceptable rate that the manager was able to achieve for the period. Sortino ratio is a suitable statistical tool for retail investors as they are more concerned about downside risks that accompany investments. It focuses on the negative deviation of an investment portfolio and its returns and thus offers a better idea about such a portfolio’s performance after potential risks have been adjusted. The Sortino ratio is the statistical tool that measures the performance of the investment relative to the downward deviation.

The only difference is that to capture downside deviations, we ignore the fund’s returns if they’re above the fund’s mean portfolio return. By penalizing only an investment’s undesirable volatility, the Sortino ratio expresses a fund’s excess return relative to its downside risk. The major difference between the Sortino ratio and the Sharpe ratio is that the Sortino ratio assumes only the downside volatility as it divides excess returns by downside volatility instead of total volatility. This ratio is useful to calculate portfolio returns for a given level of bad risk.

This results in a Sharpe ratio of 5.four [(23.6% – 1.25%) / 4.2%] which is within the 98th percentile over the past 25 years. This means that solely 2% of the time has the Sharpe Ratio been higher than it’s right now. The return of the fund is the return that your fund manager earns in absolute terms. The threat-free return is what you would have earned with none threat as in case of a bank FD. Do note that risk-adjusted returns should be used to compare schemes within the same category and with comparable indices . Bond funds had estimated inflows of US$931 million, compared to estimated inflows of US$1.99bn during the previous week.

Taxable bond funds saw estimated inflows of US$602 million, and municipal bond funds had estimated inflows of US$329 million. One reason the Sortino is yet to pick up is that the actual comparative output tends to match with Sharpe in most cases. However, in specific cases of high volatility periods or for high risk funds, the Sortino can give a smarter and more elegant analysis. A common limitation of all accounting ratios is that it is backward looking and is based on historical returns. Sharpe ratio tells us how well we are being rewarded for the amount of risk we are taking. It tells us whether the chosen fund is better in comparison with other similar options available and helps in calculating whether it is underperforming or over performing as compared to other available options.

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If you use the sortino ratio of an illiquid scheme, the risk free returns may seem favourable but in reality it is only because of the scheme’s illiquidity. The first factor to consider is the time of investments to consider. It is advised that you consider the past investments of the scheme you choose through the past few years. This will give you a clear idea of the scheme through both positive as well as negative stocks. So in this example Scheme A will give you better returns than Scheme B. However, none of these schemes can be considered to be ideal as by the rule of thumb the sortino ratio of 2 and above is considered to be ideal. The Sortino ratio aims to provide a snapshot of how a fund has balanced risk and reward by focusing specifically on downside volatility.

The Sortino Ratio is just like the Sharpe Ratio, besides that replaces the standard deviation with draw back deviation. FMPs are close-ended mutual fund schemes which invests in bonds and other debt instruments. Different types of mutual funds, including schemes within the same category, carry different risk-reward profiles. Earning higher returns is an important objective of mutual fund investment. But as we have seen, when you evaluate mutual fund schemes you cannot look at returns in isolation. As mutual funds aim to outperform the underlying market index, the Treynor Ratio can be a useful ratio for assessing the scheme’s performance.

A key aspect of sortino ratio is it specifically focuses on downside volatility of a scheme. It helps to represent a realistic idea about the downside risks that accompany a stock or a fund. In other words, this ratio helps to measure risk-adjusted returns of a particular investment scheme. This ratio is a variation of the Sharpe ratio, but it considers the downside or negative return.