How do you select

funds?

• The most simple approach would be

peformance i.e. returns, right?!

• But is it sufficient to track only returns?

There is something
more...
• The reliability of the scheme too is a
critical aspect. Reliability is nothing but
volatility.

• A scheme giving good returns but is

extremely volatile or unreliable may
not find favor with a larger number of
investors.

• This calls for a measure of

performance which takes into account
both returns as well as volatility /
reliability.
Understanding Sharpe & Sortino Ratios
– By Prof. Simply Simple
• Sharpe Ratio expresses the relationship
between performance of a scheme and its
volatility.

• A higher ratio signifies a relatively less

risky scheme.

• Mathematically is can be expressed as:

Sharpe ratio = Average returns /
Volatility (Std. Deviation)
 What does it
mean?

• Thus if the performance is average

while the volatility is very low, the ratio
becomes large.

• If one were to look at cricket for an

example, a player like Rahul Dravid will
have a decent average (let’s say 40)
and a low volatility (lets say 0.5). Hence
his Sharpe Ratio would be 40/0.5 =80.
 On the other hand…

• Virendra Sehwag could have a slightly

higher average than Dravid (let’s say 45)
but his volatility, as we all know, is quite
high.

• Either he makes big hundreds or gets out

for a very low score. Let’s presume his
volatility is 0.75. His Sharpe ratio will then
be 45/.75 = 60 (which is lower than the
Sharpe Ratio of Dravid).
 So what does this
suggest?

• Despite a higher average, Sehwag’s Sharpe ratio

is lower than that of Dravid.

• This indicates that simply looking at performance

from the average point of view is not enough to
judge a player.

• One needs to take a look at different dimensions

as well.
 Hence…

• It may be wiser to pick up Dravid for the longer

version of the game, say Test Matches and
Sehwag might be a better pick for the shortest
version of the game, say T-20.

• Also, the ratio will become large if either the

numerator increases or the denominator
decreases.
The Sharpe Ratio of Tata
Infrastructure Fund is
0.0899 for the period of
three years from 1st June,
’06 to 31st May, ’09, wherein
Risk Free Rate is assumed
at 6%.
 So what is the
Sortino Ratio?

• The Sortino ratio is similar to the Sharpe

ratio, except while Sharpe ratio uses
Standard Deviation in the denominator,
Sortino ratio uses downside deviation.

• It is important to note that while standard

deviation does not discriminate between
upward and downward volatility,
downward deviation does so.
 Thus…

• Standard deviation can be high in the case

of excessive upward movement of price and
it may result into a lower Sharpe Ratio.

• Sharpe ratio will be low because the high

standard deviation is the denominator.

• Now we may believe that the scheme is

unsuitable and therefore misrepresent the
real picture (since upward movement is
desirable from an investor’s perspective!).
• Hence it was necessary to find another ratio
which differentiates harmful volatility from
volatility in general by replacing standard
deviation with downside deviation in the
denominator.

• Thus, the Sortino Ratio was calculated by

subtracting the risk free rate from the return of
the portfolio and then dividing it by the downside
deviation.
 Conceptually speaking…

• Sortino Ratio = Performance/ Downside

deviation. The Sortino ratio measures the
return to ‘bad’ volatility.

• This ratio allows investors to assess risk in a

better manner than simply looking at excess
returns to total volatility.

• A large Sortino Ratio indicates a low risk of

large losses occurring.
• To give an example, assume investment A
has a return of +10% in year one and -10%
in year two. Investment B has a 0% return in
year one and a 20% return in year two.

• The total variance in these investments is

the same, i.e. 20%. However, investment B
is obviously more favorable. Why??

• As the Sharpe ratio measures risk using

standard deviation only, it does not
differentiate between positive and negative
volatility.
The Sortino ratio, on the other
hand, measures performance
against the downward
deviation… so it is able to spot
the negative volatility
associated with investment A
immediately and help us
classify investment B as a
more favourable investment!
The Sortino Ratio of Tata
Infrastructure Fund is
12.796 for the period of
three years from 1st June,
’06 to 31st May, ’09,
wherein Risk Free Rate is
assumed at 6%.
To Sum
Up
• Sharpe Ratio: Sharpe Ratio
expresses the relationship
between performance of a
scheme and its volatility. A
higher ratio signifies a relatively
less risky scheme.

• Sortino Ratio: The Sortino Ratio

is calculated by subtracting the
risk free rate from the return of
the portfolio and then dividing it
by the downside deviation.
Hope you have now understood the concept of
Sharpe & Sortino Ratios

In case of any query, please e-mail

professor@tataamc.com