Sortino Ratio Meaning

Sortino Ratio Meaning

The Sortino Ratio measures the risk-adjusted return of an investment. It differs from other metrics by focusing solely on downside volatility, or the “bad” volatility investors wish to avoid. This allows for a more nuanced view of risk, which is especially useful for investors more concerned about potential losses than overall volatility. 

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Sortino Ratio In Mutual Fund

The Sortino Ratio in mutual funds measures performance against the risk of negative returns. It assesses if returns justify the downside risk. This is important because high volatility isn’t always negative if it leads to significant returns, indicating a potentially favorable risk-reward scenario for investors.

Let’s say a mutual fund has a Sortino Ratio of 2.5. This would indicate that the fund is relatively efficient at compensating for the downside risks it presents. The higher the Sortino Ratio, the better the fund’s performance against its downside volatility.

Sortino Ratio Example

Consider an investor, Jane, who has invested in two different mutual funds: Fund A and Fund B. Fund A has a Sortino Ratio of 1.5, while Fund B has a ratio of 2.3. To put this into context, Fund B is offering better risk-adjusted returns compared to Fund A. Jane would be getting more return for each unit of downside risk she’s taking on with Fund B. This can be a critical factor in her decision-making process, especially if she’s looking to minimize potential losses.

Sortino Ratio Formula – How To Calculate Sortino Ratio

The Sortino Ratio formula is (Expected Return−Risk-Free Rate) / Downside Deviation. In simpler terms, you subtract the risk-free rate from the expected return of the investment and then divide it by the downside deviation. This gives you a single number representing the risk-adjusted return, focusing only on the ‘bad’ volatility.

For example, the expected return is 15%, the risk-free rate is 5%, and the downside deviation is 10%. The Sortino Ratio would be 15. A Sortino Ratio of 1 indicates that the investment returns one unit of profit for every unit of downside risk. 

Sortino Ratio Vs Sharpe Ratio

The key difference between the Sortino Ratio and the Sharpe Ratio lies in how they handle volatility. While the Sharpe Ratio considers both upside and downside volatility, Sortino Ratio focuses only on downside volatility. 

FeatureSortino RatioSharpe Ratio
Volatility ConsiderationFocuses only on downside volatilityConsiders both upside and downside volatility
Risk PerceptionPenalizes only negative volatility or downside riskTreats all volatility as risk
Ideal forInvestors concerned with negative portfolio fluctuationsThose wanting a general volatility risk measure
PrecisionOffers a more nuanced insight into undesirable volatilityProvides a broader overview of overall volatility

Sortino Ratio Interpretation

A high Sortino Ratio indicates that an investment efficiently delivers returns while minimizing downside risk. The higher the Sortino Ratio, the better the investment is at yielding returns that justify its level of downside risk.

To illustrate, if a mutual fund has a Sortino Ratio of 3, the fund provides three units of return for every unit of downside risk. In contrast, a fund with a Sortino Ratio of 1 would offer less value for the risk involved. 

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Sortino Ratio – Quick Summary

  • The Sortino Ratio in mutual fund helps gauge the efficiency of a mutual fund by comparing its returns to its downside risk.
  • Sortino Ratio Formula: (Expected Return−Risk-Free Rate)/Downside Deviation
  • Sortino ratio focuses on downside volatility, while Sharpe ratio considers both upside and downside, making Sortino more precise for risk-averse investors.
  • A higher Sortino Ratio indicates an investment efficiently delivers returns while minimizing downside risk.
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Sortino Ratio In Mutual Fund – FAQs

1. What is Sortino Ratio in Mutual Funds?

The Sortino Ratio in mutual funds measures how well the fund performs relative to the risk of negative returns. It’s a way to determine if the fund’s returns justify the downside risks. A higher Sortino Ratio indicates that the mutual fund effectively compensates for any downside volatility.

2. What Sortino ratio is good?

A higher Sortino Ratio signifies more return for each unit of downside risk, with over 2 considered excellent. However, ‘good’ varies by asset class and market conditions. A ratio below 1 might indicate inadequate returns for the assumed risk, warranting investor caution.

3. Which is better Sharpe ratio or Sortino ratio?

Choosing between Sharpe and Sortino Ratios depends on investment focus: Sortino is better for those concerned with downside risk, as it targets negative volatility. Sharpe evaluates overall volatility, including both gains and losses. Sortino provides a more detailed perspective for investors particularly cautious about losses.

4. How is the Sortino ratio calculated?

The Sortino Ratio is calculated using the formula: Sortino Ratio = Expected Return – Risk-Free Rate / Downside Deviation. 

5. What is the purpose of Sortino ratio?

The Sortino Ratio’s main purpose is to measure an investment’s performance while specifically considering downside risk. This helps investors evaluate if the returns are worth the risks taken, particularly useful for those aiming to minimize potential losses and prioritize safer investment strategies.

6. Who invented the Sortino ratio?

Frank A. Sortino developed the Sortino Ratio in the early 1980s. He introduced it as an improvement over the Sharpe Ratio to focus on downside risk specifically. The idea was to give investors a better tool for evaluating the risk-adjusted performance of their portfolios, particularly for those more concerned with losses than overall volatility.

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