Retail investors, who find it difficult to make a choice when it comes to mutual funds, can take the help of Sortino ratio to zero-in on a better scheme among several schemes available in the market.
Sortino ratio is a financial ratio that could very well be used by risk-averse or conservative investor class. The ratio provides a measure of risk-adjusted returns for a mutual fund scheme. Retail investors who have high concerns when it comes to downside risks can use the ratio. In real sense, the ratio provides the degree to which fund manager has been successful in correctly capping the downside volatility in a scheme and put forth reasonable returns. More so, the ratio gives a clear picture of the downside volatility in a scheme.
Named after the professor of Pension Research Institute, US, Dr. Frank Sortino, the Sortino ratio has been accepted largely on account of its ability to provide clearly the downside risk associated with a scheme.
How an investor can use the Sortino Ratio?
Sortino ratio is computed by deducting risk-free return from the portfolio's overall return and then devided by downside deviation instead of standard deviation.
Higher sortino ratio reflects that there is lesser chance of downside deviation in the mutual fund scheme.
Sortino ratio= R-T/ downside deviation ; where R is equivalent to annualized return
T is the targeted rate of return, benchmark for the targeted return in India is the fixed deposit rate.
Illustration to understand the Sortino Ratio: Let us say there are two mutual fund schemes under consideration A and B. A offers an annualized return of 15% and the downside deviation of 13% while B offers an annualized deviation of 10% and downside deviation of 4%.
Then taking risk adjusted rate of return as 7%,
Sortino Ratio for A= 15-7/ 13= 0.61
Sortino Ratio for B= 10-7/4= 0.75
So, even though the returns provided by scheme A are comparably higher than scheme B, scheme B gives a better picture of the downside deviation and hence is a better investment option.