Sortino Ratio

What is Sortino Ratio?

The Sortino Ratio is a financial metric that evaluates the performance of an investment relative to its downside risk. Unlike the Sharpe Ratio, which considers total Volatility, the Sortino Ratio focuses solely on negative returns, providing a clearer picture of an investment's risk-adjusted returns for those particularly concerned about losses.

This makes it a valuable tool for investors assessing Mutual Funds, stocks, or portfolios with varying levels of risk.

Why is Sortino Ratio Important?

• Emphasis on Downside Risk: Investors are typically more concerned about potential losses than gains. The Sortino Ratio addresses this by concentrating on negative volatility.

• Enhanced Risk assessment: By isolating downside risk, it offers a more nuanced view of an investment's performance, aiding investors in making informed decisions.

• Commonly Used by CFA Analysts: Financial analysts and CFA-certified professionals frequently use the Sortino Ratio to evaluate Portfolio performance and manage investment risks.

Formula for Sortino Ratio

The Sortino Ratio is calculated using the following formula:

Sortino ratio: (R) - Rf /SD

where,

• R = Expected return of the investment
• R_f = Risk-free rate of return (e.g., returns from government securities)
• SD = Standard Deviation of negative returns (Downside Deviation)

Example Calculation of Sortino Ratio

Let's consider two mutual funds:

• Mutual Fund A: Annual return of 15% with a downside deviation of 8%
• Mutual Fund B: Annual return of 12% with a downside deviation of 7%
• Risk-Free Rate: 2.5%

Sortino Ratio Calculation:

• Mutual Fund A: 15% - 2.5% / 8% = 1.56

• Mutual Fund B: 12% - 2.5% / 7% = 1.35

A higher Sortino Ratio indicates better risk-adjusted performance concerning downside risk.

Sortino Ratio vs. Sharpe Ratio

What is a Good Sortino Ratio?

A higher Sortino Ratio typically indicates better performance relative to downside risk. Here’s how it can be interpreted:

• Above 2.0: Excellent risk-adjusted returns
• 1.0 to 2.0: Good risk-adjusted returns
• Below 1.0: Riskier investment with lower returns for the risk taken

Sortino Ratio in Mutual Funds

The Sortino Ratio is often used to evaluate mutual fund performance. Investors prefer funds with a high Sortino Ratio as it implies the fund generates higher returns for every unit of downside risk.

Here are some examples of mutual funds and their current Sortino Ratios:

Note: Higher Sortino Ratios indicate better risk-adjusted returns for the downside volatility.

Sortino Ratio Calculator

You can calculate the Sortino Ratio using a simple calculator or financial software. Just input:

• Expected Portfolio Return
• Risk-Free Rate
• Standard Deviation of Negative Returns

Limitations of the Sortino Ratio

While the Sortino Ratio is a valuable tool, it's essential to be aware of its limitations:

1. Ignores Positive Volatility: It doesn't account for upside volatility, which might be relevant for some investors.
2. Assumes Normal Distribution: The calculation assumes that returns are normally distributed, which may not always be the case.
3. Data Sensitivity: The accuracy of the ratio heavily depends on the quality and accuracy of the input data.

Conclusion

The Sortino Ratio serves as a crucial metric for investors aiming to assess investments based on downside risk. By focusing on negative returns, it provides a tailored perspective for risk-averse investors. However, it's advisable to use the Sortino Ratio alongside other performance metrics to gain a comprehensive understanding of an investment's risk-return profile.

Next time you assess a fund, check its Sortino Ratio along with other metrics like the Sharpe Ratio and Treynor Ratio to make a well-informed decision.

Happy Investing!