Sortino ratio vs Sharpe ratio

Every type of investment, including mutual fund investment, involves risk. How much risk you are willing to take to generate desired returns defines your risk appetite. Generally, investors are advised to invest based on their risk appetite. With mutual funds, it is not just the returns that matter. It is also important to pay attention to how those returns are obtained compared to the risks taken, which is called risk-adjusted returns. Two quantitative metrics, Sortino and Sharpe ratios, give you insight into the volatility of assets and whether the returns justify the risk involved. In this blog, let's explore the difference between the Sortino ratio Vs. Sharpe ratio and understand its importance. 

What is the Sharpe Ratio?

Developed by William F. Sharpe, the Sharpe ratio is a key metric in evaluating risk-adjusted returns of mutual fund schemes and stocks. It is generally called “the reward-to-variability ratio”. As investors want to know how much risk is involved in an investment, they use the Sharpe ratio. It computes how much excess returns you can achieve for an asset for every unit of risk you take on. That is, this ratio tells you how much you can gain for the volatility you take on. 

Whenever you invest in highly volatile assets, this ratio is crucial to understand whether the risk involved is offset by the relatively higher risk-adjusted returns. So, this evaluation is valuable for investors who want to avoid loss. 

Sharpe Ratio Calculation

The formula for the Sharpe Ratio is 

Sharpe Ratio= Rp-Rfp

Here, 

Rp  =  return of the portfolio or investment

Rf = risk-free rate

σp = standard deviation of the portfolio's return

In the formula, the numerator represents the excess return over the risk-free rate, showing the additional return earned from taking on risk. The denominator is the standard deviation, which measures the volatility or total risk of the investment's returns.  

The investment is riskier if the volatility is higher. So, the higher the Sharpe Ratio, the better the investment's return relative to its risk. A higher ratio indicates that the investment offers more return for each unit of risk.

What is the Sortino Ratio?

The Sortino ratio is similar to the Sharpe ratio, measuring the risk-adjusted returns of a mutual fund. However, it only considers the downside risk. So, only the standard deviation of portfolio losses is considered. Instead of focusing on the total volatility of the asset, the Sortino ratio shows the excess return you can expect for every unit of downside risk you assume with the investment. 

Here, it is important to understand that all types of volatility are not bad. However, the Sortino ratio focuses only on the downside or harmful volatility that can impact your returns. So, if the volatility is favourable and the mutual fund grows in a positive direction, your risk-adjusted returns will be better when you use the Sortino ratio. 

Sortino Ratio Calculation

The formula for the Sortino ratio is 

Sortino Ratio= Rp-Rfd

Here, 

Rp  = return of the portfolio or investment

Rf = risk-free rate

σp = standard deviation of the portfolio's negative return, also called downside deviation

Differences between Sortino Vs. Sharpe ratio

The table below highlights the differences between the Sharpe and Sortino ratios:

How to Interpret Sortino and Sharpe Ratio?

Investors need to know how to interpret the Sortino and Sharpe ratios and how these can impact their returns. Generally, a higher number for both Sortino and Sharpe ratios means that the investment has better risk-adjusted returns compared to the risks involved. Here is how you can interpret both:

• High Sharpe Ratio: Indicates that the investment generates higher excess returns relative to its total risk (volatility). For example, a Sharpe Ratio above 1 is generally considered good, above 2 is very good, and above 3 is excellent. It shows that the investment efficiently converts risk into returns. It offers a good risk-reward balance, even if volatility is present.
• Low Sharpe Ratio: Indicates that the investment’s returns are not sufficiently high to justify the level of risk. A Sharpe Ratio below 1 suggests lower risk-adjusted returns. It implies the risk taken does not generate enough returns, signalling inefficiency or poor performance relative to its volatility.
• High Sortino Ratio: Indicates that the investment delivers strong risk-adjusted returns while keeping downside risk (negative returns) low. A Sortino ratio above 2 is considered good, indicating low downside volatility. The mutual fund or portfolio minimises losses effectively while generating consistent positive returns.
• Low Sortino Ratio: Indicates that the investment either offers low returns or experiences significant downside risk. A Sortino ratio below 1 suggests weak performance in managing negative returns. It shows that the investment struggles to balance returns with the risk of losses, making it less attractive for risk-averse investors.

Conclusion

Investing wisely requires tools that help balance returns with risk, and Sharpe and Sortino ratios excel in this regard. Whether you’re aiming for high returns or safeguarding against losses, these ratios can guide your decisions. Use the Sharpe Ratio to assess total risk and the Sortino Ratio for downside-specific insights. Remember, smart investing combines data-driven decisions with a clear understanding of your goals—use these ratios to build a portfolio that works for you.