Sharpe Ratio and Sortino Ratio.. How to use them for evaluating the performance of any Mutual Fund Scheme!!!

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.

For more clarity you can mail me.

SIP vs VIP

SIP - Systematic Investment Plan

An SIP is a mode of investment whereby the investor, invest a pre-determined amount on a monthly basis, on a pre-determined date, into a particular Mutual Fund Scheme. It is the most commonly use method of investment by individual investor today.

Advantages of SIP

• It gives an investor a benefit of rupee cost averaging. As investor buying every month, so he or she will be buying at dips and rises. So, over the time period investor is averaging his/her cost.
• It gives an investor a power of compounding.
• It helps an investor to avoid panic selling.
• An investor can start investing with a small amount of money say 500 rupees.
• An SIP effectively stops you from trying to time the market and bring financial discipline into investors investing method. 
• An SIP cut downs paper work which investor need to do,  with single form an investor can invest for 10 or more years into your chosen MF scheme. 

  

VIP - Value Averaging Investment Plan 

Value Averaging Investment Plan is an investing strategy that actually works on similar terms of steady monthly contributions as SIP, but it differs in its approach to the amount of each monthly contribution. In value averaging, the investor sets a target growth rate or amount on his portfolio each month, and then adjusts the next month's contribution according to the relative gain or shortfall made on the original portfolio.

Advantages of VIP

• It invests more rupee amount when markets are lower and less when markets are higher.
• In most cases it generates higher returns than normal SIP which is based on rupee cost averaging.
• It achieves lower cost of acquisition in most scenarios as compared to SIP.
• The probability of achieving target value for a portfolio is much higher and hence ideal for financial planning.
• Longer the investor horizon, higher the benefits from it.

Challenges in VIP

• The sum which investor invest each month will be highly unpredictable. So, its difficult for salaried individual whose income is constant to commit to a VIP knowing that the sums debited to his account may vary so widely. 
• In long term and constantly falling markets the investment amount may increase mush beyond the investor's cash flow.
• VIP is most effective when the market is not moving in one direction. If on starting the VIP the market is in steady decline foe many months, investors in a VIP would find themselves committing   larger sums to the equity fund, even while the investment loss value.
• In rising market it generates sell which may result in unwarranted short-term taxation and transaction charges.

Let's see how both the strategies works with an example :- 

Suppose, we are investing in any ABC mutual fund. We use both the strategies, considering that ABC Scheme's NAV's for last one year on a monthly basis. While investing in SIP Strategy, we invested Rs. 5000 per month, on a fixed date, we invest a total of Rs60000 per year and accumulate 3378 units totally. This gives us an average unit price of Rs. 18.30 with rate of return of 20.86%.

Under VIP strategy, we modify our investment every month such that if market rise we purchase less and if it dips we buy more. we invest a total of 57446 over 12 months and accumlate total 3235 units at an average price of 17.76 with rate of return 26.42%.

SIP
Date	NAV	SIP Amount (Rs.)	Units bought
1-Sep-10	20	5,000	250
1-Oct-10	19	5,000	263.16
1-Nov-10	18	5,000	277.78
1-Dec-10	19	5,000	263.16
3-Jan-11	20	5,000	250
1-Feb-11	21	5,000	238.1
1-Mar-11	18	5,000	277.78
1-Apr-11	15	5,000	333.33
1-May-11	16.5	5,000	303.03
1-Jun-11	18	5,000	277.78
1-Jul-11	17	5,000	294.12
1-Aug-11	20	5,000	250
Total Units Purchased	3,278.23
Total Amount Invested	60,000
Average price per unit	18.3
Portfolio Market Value as on 1-Aug-11	65,565
Internal Rate of Return	20.86%

VIP
Date	NAV	Target Amount	Amount Invested (Rs.)	Units Bought / Sold
1-Sep-10	20	5,000	5,000	250
1-Oct-10	19	10,000	5,250.00	276.32
1-Nov-10	18	15,000	15,000.00	833.33
1-Dec-10	19	20,000	20,000.00	1,052.63
3-Jan-11	20	25,000	25,000.00	1,250.00
1-Feb-11	21	30,000	30,000.00	1,428.57
1-Mar-11	18	35,000	35,000.00	1,944.44
1-Apr-11	15	40,000	40,000.00	2,666.67
1-May-11	16.5	45,000	45,000.00	2,727.27
1-Jun-11	18	50,000	50,000.00	2,777.78
1-Jul-11	17	55,000	55,000.00	3,235.29
1-Aug-11	20	60,000	-	-
Total Units Purchased	3,235.29
Total Amount Invested	57,446
Average price per unit	17.76
Portfolio Market Value as on 1-Aug-11	64,706
Internal Rate of Return	26.42%

(Source : PersonalFn )

Both the methods sound similar at first place, but after looking closely you'll see that they are actually quite different. Above example suggest that the VIP delivers a higher return on an average as compared to SIP. As an investor its up to you what you can and should do. If you have financial plan, then I would suggest that you need to invest a fixed amount across certain scheme for long-term and you need to avoid market timing altogether. in that case, SIP would be more suitable for you than VIP.