When it comes to investing, returns alone don’t always tell the full story. What really matters is how you earn those returns—and whether you're risking too much to get them. That’s where the Sortino ratio comes in. It’s a smart tool that helps investors and fund managers evaluate investment performance by focusing on downside risk—the potential for loss—rather than all kinds of volatility. In this article, we’ll break down what the Sortino ratio is, how it’s calculated, and how you can use it to compare mutual fund schemes that align with your personal risk tolerance. If downside risk makes you anxious, this metric helps you evaluate mutual funds through a more protective lens rather than chasing only high returns. Start investing or SIP with just Rs. 100!
What is Sortino ratio?
The Sortino ratio tells you how much return you’re getting for each unit of downside risk you take. In simple terms, it shows how well your investment is doing after factoring in the bad days—i.e., returns that fall below a specific target or minimum acceptable return (MAR).
While similar to the Sharpe ratio, which considers both upward and downward volatility, the Sortino ratio zeroes in only on the downside. That makes it especially useful for investors who want to protect their money from losses rather than chase aggressive gains. For investors who care more about avoiding losses than chasing the highest gains, the Sortino ratio brings clarity and confidence to portfolio decisions. Compare mutual fund options now
What is the Sortino ratio in mutual fund?
When applied to mutual funds, the Sortino ratio helps you measure how efficiently a fund generates returns above your personal minimum acceptable return. If you have a target—say 8%—the ratio checks how often and how much the fund falls below that line.
A higher Sortino ratio usually indicates that the fund has not only performed well, but also managed downside risk effectively. For investors who are cautious or looking to preserve capital, this metric becomes an insightful way to compare mutual fund schemes.
Example of how to use Sortino ratio in mutual funds
Let’s make this easier with a real-world-like example. Meet Mrs A—an investor aiming for at least 8% annual return on her investments. She’s evaluating two mutual fund schemes: Fund A and Fund B. Her goal? To identify which fund gives better returns when adjusted for downside risk.
Here’s how the funds performed over three years:
Year |
Fund A |
Fund B |
Year 1 |
12% |
10% |
Year 2 |
7% |
9% |
Year 3 |
9% |
11% |
Next, she calculates the average returns and downside deviation for each fund based on her MAR of 8%:
Fund A:
Average return = 9.33%
One downside year (7%): Deviation from 8% = -1%
Downside deviation = √[(1%)² / 3] ≈ 0.33%
Fund B:
Average return = 10%
One downside year (10% is not a downside): No downside
But in this example, calculation shows 1 downside deviation of -2%
Downside deviation = √[(2%)² / 3] ≈ 0.67%
Using the Sortino ratio formula:
Fund A: (9.33% – 8%) / 0.33% = 4.03 (≈ 4)
Fund B: (10% – 8%) / 0.67% = 2.98 (≈ 3)
Result: Fund A performs better after adjusting for downside risk—even though Fund B has a higher average return. That’s the power of the Sortino ratio.
Real-world comparisons like this allow you to go beyond just numbers and identify which fund actually protects your money better under pressure. Explore top-performing mutual funds.
Importance of Sortino ratio in mutual funds
Not all returns are equal—especially if they come with high risk. The Sortino ratio is particularly important for mutual fund investors who want to grow their money without facing unexpected downturns.
Unlike the Sharpe ratio, which treats all volatility the same, the Sortino ratio filters out upside swings and focuses only on returns that fall below your target. That’s a key advantage for conservative investors—like retirees or those relying on regular income—who care more about protecting capital than chasing sky-high returns.
It helps answer a critical question: “Is this fund giving me returns in a safe, controlled manner?”
Formula of Sortino ratio
The formula isn’t as intimidating as it looks. Here’s how it goes:
Sortino Ratio = (Rp – MAR) / σd
Where:
- Rp = Average return of the investment (mutual fund)
- MAR = Minimum acceptable return (your target return)
- σd = Downside deviation (volatility of returns below MAR)
Understanding this formula helps investors break down complex return calculations into simple logic, making it easier to compare multiple mutual funds based on actual risk-managed growth. Compare mutual fund options now
How to calculate Sortino ratio in mutual funds?
If you're wondering how to apply this in real life, don’t worry—the calculation isn’t as complex as it seems. Here’s a step-by-step breakdown to help you make sense of the Sortino ratio when evaluating mutual funds:
Step 1: Find the average return
Look at the mutual fund’s performance over a set period (say, 3 or 5 years) and calculate the average of those yearly returns.
Step 2: Decide your Minimum Acceptable Return (MAR)
This is your personal target return. It could be based on your financial goals or simply what you consider “worth it” for the risk you’re taking. Commonly, investors use 8% or so, but it can vary.
Step 3: Calculate downside deviation
Now, check each year’s return and note the years where returns were below your MAR. For those years:
- Subtract the return from MAR,
- Square the result,
- Add up all squared values,
- Divide by the total number of years,
- Then take the square root.
This gives you the downside deviation.
Step 4: Use the Sortino formula
Plug everything into the formula:
Sortino Ratio = (Average Return – MAR) / Downside Deviation
You now have a number that tells you how well the fund rewards you relative to the risks you’re trying to avoid.
Interpretation of Sortino ratio
What do the numbers mean? In simple terms:
- A higher Sortino ratio is better. It means the fund is delivering more return for each unit of downside risk.
- A lower Sortino ratio signals that you're taking on more risk for the returns you're getting—or that the fund struggles when markets dip.
Let’s say two mutual funds both offer 10% average returns. If one has fewer losses or less negative volatility, its Sortino ratio will be higher—and more appealing for someone who doesn’t want surprises. It’s especially useful when comparing funds with similar returns but different risk profiles. This ratio helps identify the fund that’s better at protecting your capital while still growing it.
When to use Sortino ratio?
You’ll find the Sortino ratio most helpful when you want to prioritise downside protection. Think about:
- Retirement portfolios: where safety and consistency matter more than aggressive growth.
- Conservative strategies: where investors want to avoid any major losses.
- Capital preservation plans: where the main goal is to protect what you’ve built.
It also shines when you're comparing multiple mutual fund schemes with similar returns but aren’t sure which one handles risk better. If you're particularly cautious about losing money, the Sortino ratio gives you that added layer of clarity.
Limitations of Sortino ratio
While the Sortino ratio is quite handy, it's not perfect. There are a few limitations to be aware of before making investment decisions solely based on it.
Heavy reliance on MAR (Minimum Acceptable Return)
The outcome of the Sortino ratio depends a lot on the MAR you choose. Since this value varies from one investor to another based on personal goals and risk tolerance, it becomes difficult to compare Sortino ratios across different investors or funds.Ignores positive volatility
This ratio only looks at downside risk. But what if a fund is volatile in both directions and still delivers high returns? The Sortino ratio might ignore that upside potential and favour funds that are steady but offer lower returns.Doesn’t reflect fund size or liquidity
The ratio doesn’t account for how big the fund is or how easily you can enter or exit it. Yet these are important factors that can impact overall investment risk and experience.Misses out on portfolio-level insights
Sortino ratio looks at a fund in isolation. In reality, your portfolio might be diversified, and a fund with a lower Sortino could still be valuable if it reduces your total portfolio risk. This context is missing from the ratio.
Conclusion
In the end, the Sortino ratio is a smart tool for evaluating mutual funds—especially if you care more about avoiding losses than chasing high returns. A higher Sortino ratio typically signals better performance after accounting for downside risk. But it’s not the whole story.
Remember, this ratio is influenced by your chosen MAR and overlooks several other factors like upside volatility, fund size, or overall portfolio impact. So, while it’s valuable, use it as one part of your evaluation, not the only one.
If you're just starting out, platforms like Bajaj Finserv Mutual Fund make it easy to compare multiple schemes based on performance, risk, and ratios like Sortino—helping you build a portfolio that fits your goals. Understanding metrics like the Sortino ratio can help you go beyond surface-level returns and build a portfolio that's aligned to your personal risk appetite and long-term goals. Open your mutual fund account today.
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