What is Sortino Ratio

As discussed in this blog, the Sharpe ratio shows us risk-adjusted returns, meaning how much excess returns the fund was able to generate for every additional unit of risk. 

Why do we use Sortino Ratio?

In the Sharpe ratio, we use the standard deviation in the denominator. This standard deviation calculation includes both positive and negative deviations from the mean. So even if the fund has higher positive spikes in the return profile (that is desirable), its standard deviation will be higher and the Sharpe ratio will be lower. This can be misleading as the fund is punished for providing good returns. Investors don’t care (in fact they like) positive deviations.

What is Sortino Ratio in Mutual Funds?

To eliminate this issue we use the Sortino ratio, as most investors care for only downside risks. In the case of the Sortino ratio, the only downside risk is taken into consideration. This ratio is a modified version of the Sharpe ratio. So similar to the Sharpe ratio, the higher the value of this ratio, the better the fund.

Sortino Ratio can be calculated as

Sortino ratio = (R – Rf) / SD

Where:

R = Fund Return

Rf = Risk-Free rate

SD = Standard Deviation of Negative Returns

Let’s analyze the Sortino Ratio to understand its importance.

From the above table, we can see that Fund A has a lower Sharpe ratio than Fund B. Even though Fund A has generated a higher return compared to Fund B, the latter has given better risk-adjusted returns if we consider only the Sharpe ratio.

But, if we compare the Sortino ratio of these funds, we can see that fund A has a higher Sortino ratio compared to fund B. This means when we consider only downside risk, fund A has shown a better performance. This also means that fund A has a higher total standard deviation because of the positive spikes in the return profile (which is desirable).

So, we can see that just looking at the Sharpe ratio can be misleading in some cases as the fund with a lower Sharpe ratio might have lower negative spikes in the return profile and a higher Sortino ratio. 

On sharpely, while comparing any mutual funds, you can find the Sortiono ratio of them.

FAQs

What does the Sortino Ratio indicate?

The Sortino Ratio indicates the excess return earned by a mutual fund per unit of downside risk taken. A higher Sortino Ratio indicates a better risk-adjusted performance of the mutual fund. It is a very useful metric for investors who are more concerned about downside risk than the overall volatility of the fund.

Should I invest only in funds with a high Sortino Ratio?

No. Even though a higher Sortino ratio means better risk-adjusted returns, funds with a high Sortino ratio will also have a higher risk associated with it. So, you have to analyze other factors as well. You should first estimate your risk tolerance and then invest according to your financial plan.