Are Your Fund's Returns Worth the Downside Volatility?

Question: You recently discussed the Sharpe ratio. I noticed that Morningstar.com also features the fund's Sortino ratio alongside the Sharpe ratio. What does the Sortino ratio tell me about a fund's risk/reward profile that the Sharpe ratio doesn't?

Answer: In last week's article, I discussed how you can use the Sharpe ratio to assess whether a fund's returns have adequately compensated investors for its volatility. Volatility, in this case, is measured by standard deviation, which depicts how widely the portfolio's returns as a whole varied from its average returns during a certain period of time.

Like the Sharpe ratio, the Sortino ratio aims to provide a snapshot of how a fund has balanced risk and reward. But in contrast with the Sharpe ratio, it measures risk by focusing specifically on downside volatility--how often the fund has dipped below its average returns during a period of time--to quantify a fund's risk level. That's because most investors are more concerned about downside than upside fluctuations in fund performance. After all, you may have happily pocketed the 7.6% return from  Fidelity Select Electronics (FSELX) in January of this year as well as the 2.5% gain the next month, but you may have grumbled when the same fund lost 5.0% in the following month.

How Is It Calculated?
If a fund has been around for at least three years, Morningstar will calculate a Sortino ratio for it during the one-, three-, five-, and 10-year periods.

The numerator of the Sortino represents the fund's excess returns--calculated on a monthly basis--as the difference between the portfolio return and a risk-free rate of return that Morningstar choose based on the portfolio's domicile.

But instead of using standard deviation for the denominator, as the Sharpe ratio does, the Sortino ratio uses a different measure. Whereas standard deviation measures how varied a fund's returns have been relative to its average return), the Sortino ratio's denominator aims to home in on undesirable downside deviations. The process of computing downside deviation is much like that of calculating the standard deviation for the Sharpe ratio; it's the deviation of excess returns from the mean portfolio return. The only difference is that to capture downside deviations, we ignore the fund's returns if they're above the fund's mean portfolio return. By penalizing only an investment's undesirable volatility, the Sortino ratio expresses a fund's excess return relative to its downside risk.

How Can You Use It?
As is the case with the Sharpe ratio, the Sortino ratio isn't very useful as a stand-alone data point. Instead, it's necessary to ground it into context by comparing a fund's Sortino ratio with that of another fund, index, or category to determine whether a Sortino ratio is high or low. For example, comparing the 10-year Sortino ratios of two highly rated funds in the same category-- Yacktman (YACKX) and  Auxier Focused (AUXFX)--reveals that Yacktman, with a ratio of 1.10, has generated a significantly higher return given its downside volatility than did Auxier, which had a Sortino ratio 0.67. (Our analysts like the Auxier fund, too, but the numbers give the edge to Yacktman.)

This example illustrates that you can use the Sortino ratio in conjunction with Morningstar Ratings for funds. Although both the star rating and the Sortino ratio represent risk-adjusted returns with an emphasis on downside risk, the latter helps you compare two funds' risk/reward profiles with a greater degree of specificity. Both Yacktman and Auxier are large value funds that have earned 5-star ratings, but evaluating their respective Sortino ratios against one another helps you determine which fund has the done the best job balancing risk and return.

Caveats to Remember
As useful as the Sortino ratio can be, investors need to keep in mind some caveats when using it.

Like the other metrics we've discussed during the past several weeks, the ratio is based on historical returns, which are not a reliable indicator of future outcomes (past performance is further undermined if a fund undergoes a management or strategy change). And as previously mentioned, a fund's Sortino ratio needs to be viewed in comparison with another fund, index, or category because it is not meaningful when viewed in isolation.

Moreover, investors should assess a fund's Sortino ratio in light of their investing horizon and risk tolerance in managing their portfolios. Our previous example comparing the Yacktman and Auxier Focused funds revealed that Yacktman reaped greater excess return relative to its downside volatility than did Auxier during a 10-year period. However, Yacktman's overall Morningstar Risk rating of average means that those returns were earned by taking on more risk than did Auxier, which earned a low overall risk rating. In choosing between the two, risk-tolerant investors may find Yacktman more appealing, while those who are more risk-averse may be willing to give up some gains for a smoother ride with Auxier.