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Sortino Ratio

Investing is a process that involves not only aiming for returns on your investments but also understanding the potential risks. Depending upon the risk-reward ratio, an investor can decide on the mode of investment that has the potential to meet his goals.

One of the tools that investors or mutual fund managers look at when assessing the performance of an investment is the Sortino ratio.

What is Sortino Ratio?

the Sortino ratio is a portfolio performance tool that helps investors to determine the extra returns generated for each unit of downside risk. The downside risk measures the loss the portfolio is likely to bear when market fluctuations occur.

Difference between Sortino Ratio and Sharpe Ratio

The main difference between the Sortino and Sharpe ratios is that the former only considers the standard deviation of the downside risk. Still, the Sharpe ratio considers total standard deviation, which includes both upside and downside risks.

Formula of Sortino Ratio

The calculation or formula of the Sortino ratio is expressed as follows:

Sortino Ratio = [(Actual or expected portfolio returns) – (Risk-free rate)] / [Standard deviation of the downside risk]

Example of Sortino Ratio Calculation

Consider two investment portfolios – Portfolio A with annualised returns of 15% and Portfolio B with annualised returns of 20%. If one takes into account a traditional financial instrument, the risk-free rate can be assumed at 8%. The downward deviation of Portfolio A and B can be assumed as 5% and 10%, respectively.

If you apply the Sortino ratio formula to both portfolios, then:

Sortino ratio calculation for A = (15-8)/5 = 1.4

Sortino ratio calculation for B = (20-8)/10 = 1.2

Now, Portfolio B may give better returns than Portfolio A, but if you are an investor for whom downside risk matters more, then Portfolio A works out to be the better option because its Sortino ratio is higher.

Significance of Sortino Ratio

The Sortino ratio focuses only on downside deviation. The rationale is that positive volatility or upside risk is a benefit. Thus, evaluating only the downside risk is thought to better understand a portfolio’s risk-adjusted performance because investors can get a sense of returns that may be generated for a given level of downside risk.

The higher the Sortino ratio, the better the portfolio's risk adjusted performance. If the Sortino ratio is negative, there will be no returns for the risks taken.

To conclude

The Sortino ratio is one tool among others to calculate the risk adjusted performance of a portfolio. Whether it’s a tool you would want to use will depend upon the importance you attach to potential downside risks.

FAQs

What is a Sortino ratio in mutual funds?

The Sortino ratio is a measure of portfolio performance that assesses returns that may be generated for a certain level of downside risk.

How to calculate the Sortino ratio?

The Sortino ratio is calculated by subtracting the risk-free rate of return from the actual or expected returns from the portfolio. The result is divided by the downward deviation of the portfolio.

What is a good Sortino Ratio?

A Sortino ratio of between 1 and 2 is generally considered good. However, investors might be okay with a ratio of less than 1; sometimes, the ratio can even go beyond 2. However, if the ratio is negative, it implies that there is no reward for the risks undertaken.

Which is better, Sharpe or Sortino Ratio?

The Sharpe ratio considers both upside and downside risks, while the Sortino ratio only considers downside risk.

What is the formula for calculating the Sortino ratio?

Sortino ratio = (Rp – Rf)/ D

Where Rp is the actual or expected returns on investment, Rf is the risk-free rate, and D is the standard deviation of the downside.

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