How to quantify an investment’s risk is still a big time debate topic? Judging the reliability of any Mutual Funds scheme is a critical aspect and reliability is nothing but its volatility. For example:- Mutual Fund which gives good returns but are extremely volatile may not find large investor base. So, there are two ratios which measure the performance of Mutual Funds taking both returns and volatility into account i.e. Sharpe and Sortino Ratios.
Let’s explain one by one what is Sharpe ratio and Sortino ratio.
Sharpe Ratio
Sharpe Ratio was developed by William F. Sharpe and it measures the risk premium of the portfolio relative to the total amount of risk in portfolio. It is the most popular ratio for measuring risk/return of any portfolio due to its simplicity. The Sharpe ratio tells us whether a portfolio returns are due to smart investment decisions or a result of excess risk.
Formula for calculating Sharpe Ratio
Sharpe Ratio = (Expected Portfolio returns (Rp) – Risk-Free interest rate (Rf))/ Standard deviation of the portfolio
Simple explanation of Sharpe Ratio could be that first it calculates how much rate of return of MF portfolio is. Calculated as:-
Rp – Rf means it measures the difference between the return of any portfolio of MF usually we calculate it annually and the risk free rate of return which in India is considered either of two bond rate or 181 days treasury bills. This part actually gives an idea that you would be better off by investing in MF Scheme or by buying any bond or treasury bills instead.
Let’s now think that our motto is making more money than interest rate what bond or treasury bills offer us. Here, Sharpe ratio asks a question: whether you are making money because of your skills or you are just risking your investment more than other investors??
For answering this question, Sharpe ratio divides (Rp-Rf) with standard deviation of portfolio. We divide it by standard deviation because it gives us how much return of your portfolio rises or falls compared to its mean returns in a given year or period. In other words, if returns of a given portfolio are so volatile that they change considerably up and down, then it means that your portfolio is exposed to a higher risk because its performance is changes quickly in both favourable and unfavourable directions.
How Sharpe Ratio be used effectively
If we take into account atleast 3 years of a portfolio’s performance for calculating Sharpe ratio than Sharpe ratio work best. But we need to keep this in mind that standard deviation only measures the volatility of a particular funds’s return in absolute terms not relative to its benchmark index.If no other information is given, then it’s quite difficult to comment whether a Sharpe ratio of 3 is good or bad.
When you compare one portfolio Sharpe ratio with another portfolio then only you’ll get its risk – adjusted returns. And if you use this ratio in combination with other measures, then it help investors to develop a strategy that matches both their return needs and risk tolerance.
Sortino Ratio
Sortino Ratio was developed by Brain M. Rom and named for Dr. Frank A. Sortino, a famous downside risk optimization. Sortino ratio is the statistical tool which measures the performance of the portfolio to the downward deviations. A modification of the Sharpe ratio that differentiates harmful volatility from general volatility by taking into account the standard deviation of negative asset returns called downside deviation while Sharpe ratio takes into account both upside and downside deviations.
Explanation :- Standard deviation involves both the upside as well as downside volatility. Since, Investors are more concerned about downside volatility; Sortino ratio gives a more realistic approach of the downside risk present in the Mutual Fund.
Formula for calculating Sortino Ratio
Sortino Ratio = (Expected Portfolio returns (Rp) – Risk-Free interest rate (Rf))/ Downside deviation of the portfolio
How Sortino Ratio be used effectively
Sortino Ratio usually calculated for those funds which have least tolerance for risk. Sortino ratio helps in these cases or we can say compliment to an investment strategies which are risk-averse. Sortino ratio actually gives investors an outlook that how to assess risk in a focused manner rather than simply looking for excess return on total volatility. Higher the ratio, the better a portfolio has performed relative to the risk taken. Sortino Ratio usually used to compare the risk taken between different portfolios to achieve a certain return.
Same as Sharpe Ratio when you compare one portfolio Sortino Ratio with another portfolio then only you’ll get its risk – adjusted returns. And if you use this ratio in combination with other measures, then it help investors to develop a strategy that matches both their return needs and risk tolerance.
Sortino Ratio Vs Sharpe Ratio
If we compare both the ratio then they are similar, however both use a different methods of calculation. Sharpe ratio use Standard deviation where as Sortino Ratio uses downside deviation at the denominator instead of standard deviation because Standard deviation takes into consideration both upside and downside volatility. By using Downside deviations, Sortino ratio just penalizes for harmful volatility in portfolio. As this ratio, discards all upside deviation which provides excessive profit. It basically guides investor to set a minimum acceptable rate of return with which an investor would be comfortable. Any return which portfolio earn above this rate is not included for the purpose of calculating the Sortino Ratio.
Note:- This blog is not for recommendation purpose, hence, investors must look other measures too for evaluating the performance of any Mutual Fund Scheme.
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