If you are an investor who wants to evaluate the performance of your mutual fund portfolio, you may have heard of the term Sortino ratio. But what is it and how can it help you make better investment decisions? In this blog post, we will explain what Sortino ratio is, how it is calculated, and why it is useful for reviewing portfolio performance in mutual funds.
What is Sortino ratio?
Sortino ratio is a measure of risk-adjusted returns used to analyze investment performances. It is used in the field of mutual funds to compare the risk-adjusted returns of different investments. It is a variation of the Sharpe ratio, which is a measure of risk-adjusted returns used to compare the performance of different investments.
The difference between Sortino ratio and Sharpe ratio is that Sortino ratio only considers the downside risk, while Sharpe ratio considers both upside and downside risk. Downside risk is the risk of losing money when the market goes down, while upside risk is the risk of missing out on potential gains when the market goes up. Investors are usually more concerned about downside risk than upside risk, as they want to protect their capital from losses.
How is Sortino ratio calculated?
The formula for Sortino ratio is:
Sortino ratio = (Portfolio return – Risk-free rate) / Downside deviation
Portfolio return is the annualized return of the investment portfolio over a given period.
Risk-free rate is the return of a risk-free investment, such as a government bond or treasury bill.
Downside deviation is the standard deviation of the negative returns of the portfolio. It measures how much the portfolio deviates from its expected return on the downside.
A higher Sortino ratio indicates that the portfolio has higher returns for each unit of downside risk. A lower Sortino ratio indicates that the portfolio has lower returns for each unit of downside risk.
Why is Sortino ratio useful for reviewing portfolio performance in mutual funds?
Sortino ratio is useful for reviewing portfolio performance in mutual funds because it helps investors to:
- Compare different mutual funds based on their risk-adjusted returns. Investors can use Sortino ratio to select mutual funds that have higher returns for a given level of downside risk, or lower downside risk for a given level of returns.
- Evaluate the performance of a mutual fund manager. Investors can use Sortino ratio to assess how well a mutual fund manager has managed the downside risk of the portfolio and generated excess returns over the risk-free rate.
- Monitor the performance of their own portfolio. Investors can use Sortino ratio to track how their portfolio is performing over time and whether it meets their risk-return expectations.
Example of Sortino ratio
Let us take an example of two mutual funds, A and B, that have the following annualized returns and downside deviations over a five-year period:
- Fund A: Return = 15%, Downside deviation = 5%
- Fund B: Return = 20%, Downside deviation = 10%
Assuming that the risk-free rate is 8%, we can calculate the Sortino ratios of both funds as follows:
- Sortino ratio of Fund A = (15 – 8) / 5 = 1.4
- Sortino ratio of Fund B = (20 – 8) / 10 = 1.2
Based on these calculations, we can see that Fund A has a higher Sortino ratio than Fund B, which means that Fund A has higher returns for each unit of downside risk than Fund B. Therefore, Fund A may be a better choice for investors who are more concerned about downside risk than upside risk.
Sortino ratio is a useful tool for reviewing portfolio performance in mutual funds, as it helps investors to compare different mutual funds based on their risk-adjusted returns, evaluate the performance of a mutual fund manager, and monitor the performance of their own portfolio. By using Sortino ratio, investors can make more informed and rational investment decisions that suit their risk-return preferences.