Sortino Ratio

What is Sortino Ratio?

The Sortino Ratio in the context of mutual funds is a performance metric used to evaluate the risk-adjusted returns of a mutual fund, specifically focusing on downside risk. It helps investors understand the performance of a mutual fund in respect to the negative return risk instead of overall volatility.

Key features of Sortino Ratio

• Emphasizes downside risk by measuring only negative return deviations.

• Measures risk-adjusted returns to assess effective loss management.

• It compares funds based on downside risk and returns.

Formula for Sortino Ratio

The Sortino Ratio for a mutual fund is calculated as:

Sortino Ratio = (R - r) / Downside Deviation

Where:

R : The fund's average return.

r: The target or required rate of return (e.g., risk-free rate, inflation rate, or a specific benchmark).

Downside Deviation: The standard deviation of negative returns (returns below the target).

Example

Suppose a mutual fund has:

An average annual return (R)of 10%.

A target return (r) of 4% (e.g., risk-free rate).

A downside deviation of 3%.

The Sortino Ratio would be:

Sortino Ratio = 10% − 4% /3% = 2.0

This means the fund generates 2 units of return for every unit of downside risk.