Sortino Ratio vs Sharpe Ratio: The Ratio to Judge your Portfolio
The success of the portfolio manager depends upon the overall performance of the portfolio. But one cannot judge the performance of the portfolio manager just on total returns, but on the risk–adjusted return. High risk will be associated with higher returns. But if things go wrong, then there is always a potential downside risk. Risk–adjusted return helps to avoid that extra risk which may impact the overall performance of the fund. For the investor perspective too, before selecting any mutual fund, one should look for the risk–adjusted return rather than a simple return. This is mainly because the latter (simple return) ignores the risk taken by the fund to generate returns. To better judge the risk–adjusted return of an investment portfolio, an investor should have an idea about the financial ratio. A financial ratio is a tool to analyze various fund performance.
- Sharpe Ratio:
The Sharpe ratio is popularly known as the reward-to-variability ratio, is the most common portfolio management metric. It is a measure of the risk- adjusted return of a financial portfolio. It is a measure of an excess portfolio compared to the risk–adjusted returns. It helps to study the risk–adjusted performance of a mutual fund. It is defined as the excess returns of the scheme, divided by the standard deviation scheme return over a certain period. The basic formula for the Sharpe ratio is:
Sharpe Ratio : R(p)- R (f)/ S(p)
Where R(p) = Portfolio return
R( f) = Risk free rate of return
S(p)= Standard deviation of the portfolio.
For instance, if two funds offer similar returns, then one with the higher standard deviation will have a lower Sharpe ratio. To better understand the relevance of it, let’s suppose there are two funds A and B. Where Fund A provides a return of 10% a year, while Fund B provides a return of 8% yearly. If the risk-free interest rate (mainly considered as government fixed deposit) is 4% and the standard deviation is 8% and 4%. Then the Sharpe ratio will be 0.75 and 1. Now, looking for this perspective, despite Fund A has a higher return, Fund B has a better risk–adjusted front.
- Sortino Ratio:
It is basically a tool that measures the performance of the investment relative to the downward deviation. Unlike Sharpe, this doesn’t consider the total volatility of the investment. This is well suited for the retail investor as they are more concerned about the downside risk of investment. The Sortino ratio formula will be:
Sortino Ratio: R- R(f)/SD
Where, R = Expected returns
R (f) = Risk free rate of return
SD= Standard Deviation of the Negative Asset return
To better understand this, let suppose scheme A has an annualised return of 15% and the downside deviation of the scheme is 13%. Consider a scheme B which has generated annualised returns of 10% and its downside deviation is 4%. Let’s assume that risk free returns be 7%. The Sortino ratio of scheme A will be ( 15%-7%)/13% is equal to 0.61% and the Sortino ratio of scheme B will be ( 10%-7%)/13% is equal to 0.75%. Despite the fact the A has better returns, but Scheme B has a better Sortino ratio. Hence B will be a better investment option than A.
The Bottom Line:
Despite both ratios are used for fund analysis or performance metric, fund manager mainly uses the Sharpe ratio as a metric to measure low volatility investment portfolio, while the Sortino variation is used to evaluate high-volatility portfolios.
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