What Is Sortino Ratio In Mutual Funds?

Watching the value of your mutual fund investments fall after months of gains can make you question how much volatility you are prepared to tolerate. You may accept occasional declines as part of investing, yet you would still want to know whether the returns you eventually earn justify taking that risk. When you begin examining a fund’s performance from this perspective, you may encounter Sortino ratio.

A mutual fund can deliver attractive returns over several years while experiencing substantial declines during that period. Its average return tells you how the investment has performed overall, although it offers limited insight into the weaker returns recorded along the way. Sortino ratio helps you examine this aspect of a fund’s historical performance before comparing mutual fund schemes.

What is Sortino ratio in mutual funds

Sortino ratio measures how much return a mutual fund has generated relative to the downside risk it has experienced. To understand its significance, consider what happens when a fund’s performance deteriorates.

Suppose your mutual fund generates a return of 12% in one year but records a loss of 7% in the following year. The negative return indicates that the fund’s value has declined during that year. Such losses concern investors because they reduce the value of their investments, sometimes considerably.

This possibility of experiencing unfavourable returns is known as downside risk. For Sortino ratio, however, downside risk has a specific meaning: it concerns returns falling below a selected minimum acceptable level. For instance, if that minimum is set at 0%, the calculation considers periods when the fund records negative returns. A year in which it loses 7% would contribute to the downside risk calculation, while a year in which it gains 12% would not.

The minimum acceptable return can also be set above zero. Suppose you choose 6% as the minimum annual return for evaluating a fund. If the fund generates 4%, it has earned a positive return, although its performance has fallen two percentage points below your chosen minimum. This shortfall would also be considered in Sortino ratio calculation.

Financial analysts measure the extent of these shortfalls through downside deviation. It accounts for how far a fund’s periodic returns have fallen below the selected minimum, with larger shortfalls contributing more heavily to the calculation.

Sortino ratio then compares the fund’s average return above that minimum with its downside deviation. A higher ratio generally indicates that the fund has generated greater returns relative to its historical downside risk, provided the funds being compared use the same calculation method and return target.

How is Sortino ratio useful?

Consider two equity mutual funds that have generated an average annual return of 10% over five years. Their performance may appear equally attractive when you look at their average returns, although the fluctuations they experienced during those years could have been considerably different.

One fund may have suffered substantial losses in certain years before recovering through strong gains, while the other may have experienced smaller declines and maintained relatively consistent returns. Despite earning similar average returns, you would have experienced different levels of downside risk in these two funds.

Sortino ratio helps you examine this difference. Suppose you use 0% as the minimum acceptable annual return for both funds. The years in which either fund recorded losses would contribute to its downside deviation, with larger losses having a greater effect on the calculation. If one fund consistently experienced smaller shortfalls while generating the same average return, it would have a higher Sortino ratio.

This is what downside-risk-adjusted performance measures: the return a fund has generated in relation to the extent of its returns falling below the selected minimum. A higher Sortino ratio indicates that the fund has delivered more return relative to its measured downside deviation during the period examined.

However, a higher ratio doesn’t necessarily indicate smaller historical losses. It can also result from stronger average returns that compensate for considerable downside fluctuations. You should therefore examine both the fund’s returns and the declines it experienced to understand what contributed to its ratio.

You can compare these performance measures through 1 Finance Mutual Fund Scoring and Ranking model⁠, which evaluates mutual fund schemes using risk-adjusted ratios, including Sortino ratio, alongside other factors such as fund manager performance. For a meaningful comparison, select funds from similar investment categories and examine their performance over the same period.

Your investment horizon also influences how you use these findings. For instance, if you plan to redeem your investment within the next two years, even a fund with a favourable historical Sortino ratio could experience a market decline before your redemption date. You need to consider whether you can absorb such a loss without compromising the financial goal for which you invested.

The article, Choose mutual funds the right way: Start with yourself, not the fund, explains how these personal considerations influence mutual fund selection.

Sortino ratio vs Sharpe ratio: What’s the difference

While evaluating mutual fund performance, you may also come across Sharpe ratio. Both measures help you assess investment returns relative to risk, although they examine volatility differently. Volatility refers to fluctuations in a mutual fund’s returns over time. These fluctuations can occur when the fund generates unusually high returns or experiences sharp declines.

Sharpe ratio evaluates how much return a mutual fund has generated above a relatively low-risk reference rate for each unit of overall volatility. It uses standard deviation, which measures how widely the fund’s returns vary around their average.

This calculation accounts for fluctuations in both directions. For example, if a mutual fund experiences unusually strong gains during certain periods, those returns contribute to its standard deviation because they differ substantially from the average.

Sortino ratio uses downside deviation instead. Its calculation concentrates on periods when the fund’s returns fall below the selected minimum acceptable return. Returns above that target make no contribution to the downside deviation measure.

When should you use Sharpe ratio or Sortino ratio?

Sharpe ratio is useful when you want to understand a fund’s returns in relation to its overall volatility. It helps you assess how widely the fund’s performance has fluctuated while generating returns above the reference rate.

Sortino ratio becomes particularly relevant when your concern is how often, and by how much, a fund’s returns have fallen below a specified minimum. It helps you assess whether the return generated has adequately compensated for those shortfalls.

Considering both ratios can provide a broader understanding of how the fund has performed. A favorable Sortino ratio, for instance, may coexist with considerable overall volatility, which becomes apparent when you also examine Sharpe ratio.

You can extend this assessment through other performance measures. Beta helps you understand how sensitive a fund’s returns have been to movements in its benchmark, while Alpha assesses performance relative to the return expected after accounting for market risk. Each measure examines a particular aspect of investment performance, allowing you to understand the fund beyond its reported returns.

How to calculate Sortino ratio in mutual funds

To calculate the Sortino ratio, you need the mutual fund’s average return, a minimum acceptable return and its downside deviation over the period being assessed. The calculation compares the fund’s average return above your chosen target with how much its returns have fallen below that target.

Sortino ratio formula

Sortino ratio = (Average return − Minimum acceptable return)/Downside deviation

Here’s what each component represents:

• Average return is the arithmetic average of the fund’s returns over the selected period. If you’re examining five annual returns, you add them together and divide the total by five.
• Minimum acceptable return is the return you choose as a reference for identifying underperformance. You could use 0%, a relatively low-risk reference rate or another return target appropriate to the analysis.
• Downside deviation measures how far the fund’s returns have fallen below your chosen target, accounting for the size and frequency of those shortfalls.

Both the average return and downside deviation must use consistent time intervals. For example, if you’re using annual returns, your minimum acceptable return must also be expressed annually.

Sortino ratio example using five years of mutual fund returns

Consider an equity mutual fund with the following annual returns over five years. These are hypothetical figures, with each percentage representing the fund’s gain or loss during that particular year.

Year	Annual return
Year 1	18%
Year 2	−10%
Year 3	22%
Year 4	−5%
Year 5	15%

For this calculation, we’ll use 0% as the minimum acceptable annual return. This means we’re interested in the years when the fund lost money, as any return below zero falls short of our chosen target. We’ve selected 0% to keep the example straightforward. When evaluating an actual mutual fund, the minimum acceptable return may be different depending on the purpose of your analysis.

Step 1: Calculate the average annual return

The fund recorded positive returns in three years and negative returns in two. To find its average annual return, add all five percentages, including the negative ones, and divide the total by five.

• Average annual return = (18% − 10% + 22% − 5% + 15%)/5
• Average annual return = 8%

The fund’s arithmetic average annual return was 8% over these five years. This is the figure we’ll use in the Sortino ratio formula.

Step 2: Calculate the downside deviation

The fund lost 10% in Year 2 and 5% in Year 4. Since we’ve selected 0% as the minimum acceptable return, these are the two years when the fund fell below our target. The other three years recorded positive returns, so they have no shortfall against the 0% target. We’ll assign them a shortfall of zero.

Year	Annual return	Shortfall below 0%
Year 1	18%	0
Year 2	−10%	10 percentage points
Year 3	22%	0
Year 4	−5%	5 percentage points
Year 5	15%	0

To calculate downside deviation, we square each shortfall, add the squared values and divide the total by the number of years observed. Finally, we take the square root of the result.

Squaring a number means multiplying it by itself. For example, a shortfall of 10 percentage points gives 10 × 10 = 100, while a shortfall of 5 percentage points gives 5 × 5 = 25. This calculation gives greater weight to larger shortfalls.

Using the figures from our table:

• Downside deviation = √[(10² + 5²)/5]
• = √[(100 + 25)/5]
• = √25
• Downside deviation = 5%

We divide by all five years because we’re assessing the fund’s returns over the entire period, including the years with zero shortfall. Taking the square root brings the calculation back to the same percentage scale as the original returns.

The resulting 5% represents the fund’s downside deviation against our chosen 0% target over these five annual observations.

Step 3: Apply the Sortino ratio formula

We now have the three figures required for the calculation.

• Average annual return: 8%
• Minimum acceptable annual return: 0%
• Downside deviation: 5%

Sortino ratio = (8% − 0%)/5% = 8%/5%

Sortino ratio = 1.6

A Sortino ratio of 1.6 means the fund’s average return above the chosen target was 1.6 times its downside deviation during the five-year period. The result is a ratio rather than a percentage. When comparing similar funds using the same time period and target, a higher Sortino ratio generally indicates a more favourable return relative to downside risk.

The 22% return in Year 3 might catch your attention when you’re shortlisting mutual funds. However, funds that rank among the top performers in one period can fall considerably in the next, which is why a single year’s high return deserves closer scrutiny. In our example, the fund also experienced losses in two years, and its Sortino ratio accounts for their impact against the selected return target.

Five annual observations make the calculation easier to understand, although they provide limited information about a fund’s downside risk. A more detailed assessment would examine a longer return history using a consistent calculation method.

How to interpret Sortino ratio: What is a good value?

You’ve calculated a Sortino ratio of 1.6, but is that considered good? There is no universally accepted number that makes a Sortino ratio good for every mutual fund. Its usefulness becomes clearer when you compare mutual funds with similar investment objectives, using the same period, return target and calculation method.

The ratio can also be positive, zero or negative. A positive value means the fund’s average return exceeded your chosen target, while a negative value means it fell short. A zero ratio indicates that the average return matched the target, provided the downside deviation was greater than zero.

If none of the observed returns falls below the target, the downside deviation becomes zero, making the standard formula undefined. This doesn’t establish that the fund has no downside risk, as future returns may fall below the target.

The period you examine can also influence the result. A fund assessed during predominantly rising markets may have experienced fewer shortfalls, producing an unusually high ratio. Looking at its performance during less favourable market conditions can help you assess whether that historical result is representative.

Consult a Qualified Financial Advisor to evaluate mutual fund performance

Consider a fund with a favourable Sortino ratio that experiences a substantial decline during a market correction. If you’re planning to use that money for a house down payment next year, waiting for the investment to recover could delay your plans. Examining the fund’s historical drawdowns, or declines from previous peaks, and how long it took to recover can help you understand the extent of such risks.

A Qualified Financial Advisor (QFA) can evaluate these findings alongside the fund’s portfolio composition, investment category and fund manager’s track record. They can also assess whether your existing and proposed mutual fund investments suit your financial goals, investment horizon and capacity to absorb losses, while considering the other financial commitments that influence your overall financial plan.