Smart investing: Using Sortino Ratio to choose mutual funds

Mutual funds, especially equity based mutual funds, are one of the most popular investment instruments. But often, investors find it difficult to choose the right scheme or fund. With hundreds of equity mutual funds and each claiming the best returns, it is quite confusing to choose the right fund.

To make the process easy and simple, investors can depend upon one financial ratio known as Sortino Ratio to select a better fund. Investors are only concerned about the downward volatility, so focusing on this ratio makes sense.
Mechanics of Sortino ratio

This ratio has been propounded by Frank A Sortino who is considered the father of post modern portfolio theory. Basically, this ratio captures the harmful volatility from total overall volatility by using downside deviation. This ratio is computed by deducting risk-free return from the portfolio’s overall return and then dividing it by downside deviation. Higher Sortino Ratio reflects that there is less probability of downside deviation in the mutual fund scheme.

Symbolically, Sortino Ratio = R – T/ Downside deviation, where R is the annualised return; T is the targeted rate of return. Assuming that as an investor you are considering two mutual funds; namely, X and Y. X offers an annualised return of 15% and the downside deviation of 13% whereas Y offers an annualised return of 10% with a downside deviation of 4%. Assuming that risk adjusted rate of return was 7%, Sortino Ratio for X = (15-7) / 13 = 0.61 and for Y = (10-7)/4 = 0.75.

Though Fund X offers a higher return 15% compared to Fund Y 13%, Fund B gives a better return during the downside market times and hence it is a better investment option for investors who are conservative. A higher Sortino Ratio indicates that the investment is earning higher return for every unit of bad risk taken. Higher the Sortino Ratio, better is the fund. Thus, Sortino Ratio measures the performance of the investment relative to the downward deviation.

Limitations
This ratio, like any other ratios, is based on historical returns, which may not be a reliable indicator of future outcomes and this ratio cannot be interpreted separately. This fund needs to be assessed in comparison with another comparable fund because it is not meaningful when viewed in isolation. Further, investors should assess a mutual fund’s Sortino Ratio in the context of their holding period or investment horizon and risk tolerance level in managing their overall portfolios.

To conclude, as the Sortino Ratio is best suited for conservative or risk-averse investors since it focuses only on the negative deviation of a portfolio’s returns from the mean, it provides a better view of a portfolio’s risk-adjusted performance since positive volatility is a benefit.

RISK RATIOS
Sortino Ratio captures the harmful volatility from total overall volatility by using downside deviation
Higher Sortino Ratio reflects that there is less probability of downside deviation in the mutual fund scheme
This ratio is based on historical returns which may not be a reliable indicator of future outcomes
Assess a mutual fund’s Sortino Ratio in the context of your holding period or investment horizon and risk tolerance level in managing their overall portfolios
It is not meaningful when viewed in isolation and two funds have to be compared

The writer is a professor of finance & accounting, IIM Tiruchirappalli