The most simple approach would be peformance i.e. returns, The most simple approach would be peformance i.e. returns,

right?!right?!

But is it sufficient to track only returns?But is it sufficient to track only returns?

How do you select funds?

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.

There is something more…

Understanding Sharpe & Sortino Ratios

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)

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.

What does it mean?

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).

On the other hand…

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.

So what does this suggest?So what does this suggest?

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.

Hence…Hence…

The Sharpe Ratio of Tata The Sharpe Ratio of Tata

Infrastructure Fund is 0.0899 for Infrastructure Fund is 0.0899 for

the period of three years from the period of three years from

1st June, ’06 to 31st May, ’09, 1st June, ’06 to 31st May, ’09,

wherein Risk Free Rate is wherein Risk Free Rate is

assumed at 6%.assumed at 6%.

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.

So what is theSo what is theSortino Ratio?Sortino Ratio?

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!).

Thus…

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.

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.

Conceptually speaking…Conceptually speaking…

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, The Sortino ratio, on the other hand,

measures performance against the measures performance against the

downward deviation… so it is able to spot downward deviation… so it is able to spot

the negative volatility associated with the negative volatility associated with

investment A immediately and help us investment A immediately and help us

classify investment B as a more favorable classify investment B as a more favorable

investment!investment!

The Sortino Ratio of Tata Infrastructure The Sortino Ratio of Tata Infrastructure

Fund is 12.796 for the period of three Fund is 12.796 for the period of three

years from 1st June, ’06 to 31st May, ’09, years from 1st June, ’06 to 31st May, ’09,

wherein Risk Free Rate is assumed at 6%.wherein Risk Free Rate is assumed at 6%.

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.

To Sum Up