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Evaluating Equity Fund Selections - Two Ratios Investors Should Consider Reviewing

January 24, 2022

When reviewing and comparing equity mutual fund/ETF performance, investors in their portfolios/IRAs/401(k) plans typically compare historical returns over time periods such as the last three/five/ten years and whether one fund has outperformed another fund.  Investors often omit considering the risk one fund manager’s strategy has taken over another manager’s fund strategy over the same time period.  Fortunately, there are two ratios that enable investors to compare the historical risk taken among equity fund managers.

The first ratio to consider when comparing the risk-adjusted performance among mutual funds/ETFs is the Sharpe ratio for each security.  The Sharpe ratio was presented in an article written by William Sharpe and published in the Journal of Business in 1966.  Simply, the Sharpe ratio measures the risk-adjusted return per unit of risk.  Where the risk-adjusted return is the excess fund return (over Treasury Bills rate) divided by the standard deviation of the fund/ETF returns.  Fund/ETF Sharpe ratios typically range from 0.5 to 1.5 over varying time periods (thee/five/ten years) where the higher the number, the greater the return per unit of risk taken over that specific time period.  Note Morningstar advises in its software definitions that a fund/ETF with a higher Sharpe ratio does not suggest that the fund will have lower future volatility.

A second ratio to consider when comparing the risk-adjusted performance among mutual funds/ETFs is the Sortino ratio for each security over the same time period.  The Sortino ratio is similar to the Sharpe ratio in calculation but measures risk-adjusted returns over down market time periods only.  The Sortino ratio was presented in an article written by Frank Sortino and Lee Price and published in the Journal of Investing in the Fall 1994.  Fund/ETF Sortino ratios typically range from 0.5 to 2.0 over varying time periods (three/five/ten years) where the higher the number, the greater the return per unit of down side risk over that specific time period.

Where can investors locate the Sharpe and Sortino ratios to compare?  Investors may need to: 1) checkout fund family websites or contact fund families directly and request the information; 2) request their financial advisor and/or retirement plan sponsor provide more detailed fund information that includes return and risk information over at least the last three/five years; or 3) checkout your public library website or the Morningstar.com website for fund information.  Financial advisors should be able to discuss the basis of their fund recommendations in terms of return and risk over time periods.  Retirement plan sponsors need to hear from participants that providing detailed fund risk information is helpful when comparing existing funds and making decisions among funds in their plan.

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Written by Philip Horn - Iowa State Bank VP, Investment Officer