Previously, in this column, we discussed SEBI’s proposal for asset management companies (AMCs) to disclose Information Ratio (IR) for each of their funds. IR is appropriate for investing surplus cash as such investments do not have a time horizon nor the need to earn a required return to achieve a life goal. Sortino Ratio (SR) is more appropriate for goal-based investments in mutual funds. Here, we discuss why SR is a better measure and why it would be useful if AMCs also disclose this metric alongside IR.
Downside risk
For goal-based investments, you must define risk and required return. The required return is the minimum return your investment must earn over a given time frame to accumulate the money needed to achieve desired goal. Call this Minimum Acceptable Return or MAR. This is the expected post-tax compounded annual return.
The risk is goal-based investments can earn lower than MAR in any year during the time horizon for a goal. So, downside deviation is a better measure of risk than standard deviation, for the latter measures both the upside and downside deviation. To determine MAR, you must define the time horizon, the amount needed to achieve the goal and the amount you can save. If MAR is 8.5%, it means your combined investments in equity and bonds will need to earn 8.5% annually to achieve the goal.
Suppose the pre-tax expected return on equity is 12% and post-tax return is 10.5%. The SR is calculated as the excess return of the fund over the pre-tax equity MAR divided by downside deviation of returns below the equity MAR. This tells you about the risk of investing in the fund to achieve a goal as SR is related to MAR.
Conclusion
The MAR to determine SR is the expected pre-tax annual return on equity and is independent of the goal you pursue. Hence, AMCs can report SR for each fund alongside the IR. Importantly, AMCs must use uniform equity MAR for determining SR. Otherwise, comparing SR among peer funds may not be meaningful. It would be useful to have AMCs disclose SR over one-, three-, five- and 10-year periods and since inception. The time horizon is very specific to each goal. So, you must determine the consistency of a fund’s SR in relation to your goal’s time horizon based on the information provided.
(The author offers training programmes for individuals to manage their personal investments)