The Sortino Ratio helps measure the risk-adjusted return of an investment. Both it and the Sharpe Ratio determine an investment’s return through risk-adjusted methods. However, the Sortino Ratio only factors in downside volatility. Learn about the Sortino Ratio, how people use it, and how it can benefit investors.
Named after economist Frank A. Sortino, the Sortino Ratio subtracts a portfolio’s risk-free rate from its return. It then divides that number by the investment or asset’s downside deviation. That’s measure of downside risk that considers whether an asset or investment falls below a certain threshold. For example:
Sortino Ratio = Return Risk-free rate / Downside Deviation
The Sortino Ratio helps an investor determine an investment’s return relative to risk. It may also differentiate between investments with varied returns and risk profiles. As a result, it essentially helps level the playing field when it comes to risk. Consequently, the Sortino Ratio can help investors determine if an investment’s returns are high enough, It does so by considering the investment’s downside risk.How to Use It
The Sortino Ratio typically gives investors and portfolio managers an accurate read of a particular investment’s return. It considers the amount of inherently bad risk, or downside deviation. In financial terms, it helps determine an investment’s risk-adjusted returns as it relates to downside risk.
When applying the ratio to an investment, a higher number is better. That high number signifies the amount of return per unit of bad risk. So, a higher number represents a higher return as it relates to that investment’s risk. This can help investors. Generally speaking, a rational investor wants compensation in the form of higher returns when taking on extra risk. This ratio may help an investor find investments with a higher return per unit of downside risk.Sortino Ratio in Action
As we noted earlier, a higher ratio is better. An investor comparing two investments would take one with a higher ratio because it earns more per unit of risk.
For example, let’s say an investor looks at two mutual funds. The first, Mutual Fund S, has a 15% annual return and an 11% a downside deviation. Meanwhile, Mutual Fund A has a 20% annual return, but a 17% downside deviation of 7%. With risk-free rate of 2.5% here’s how the ratios calculate:
Mutual Fund S: 15% 2.5% / 11% = 1.14
Mutual Fund A: 20% 2.5% / 17% = 1.03
In this example, Mutual Fund A is returning 5% more per year. However, Mutual Fund S is earning its returns more efficiently. By this raition, Mutual Fund S is the better investment.
You can also use expected returns in place of the risk-free rate of return. However, try to keep things consistent if you want an accurate ratio.Sortino Ratio vs. the Sharpe Ratio
As mentioned, both the Sortino Ratio and the Sharpe Ratio are risk-adjusted tools for determining an investment’s risk, though the Sortino Ratio is a variation of the Sharpe Ratio, which was created by Nobel laureate William F. Sharpe.
The Sortino Ratio only accounts for the negative volatility of an investment, while the Sharpe Ratio takes into account total volatility. More specifically, the Sortino Ratio takes into account an asset or portfolio’s risk-free rate, its return, and most importantly, its downside deviation — or the amount of negative volatility that particular asset contains.
Alternately, the Sharpe Ratio is calculated using risk-free rate, return, and standard deviation of that asset or portfolio. Standard deviation, as you remember, is the total volatility of an investment. That’s both negative and positive volatility. So yes, even an investment’s unexpected returns fall under the umbrella of standard deviation.
Proponents of the Sortino Ratio argue that it’s actually a more efficient measure of risk and return because it only takes into account downside deviation when it considers risk. You’ll remember that the Sharpe Ratio takes into account total volatility, meaning both down and upside volatility. The latter is interesting because upside volatility, meaning volatility as it relates to positive returns, is generally good for investors.The Bottom Line
Both the Sortino Ratio and the Sharpe Ratio are risk-adjusted tools for measuring an investment’s risk. However, the Sortino Ratio uses an asset’s downside deviation as a major factor in its calculation, which is useful for investors and portfolio managers alike because its indicative of inherently “bad” risk. In other words, that ratio helps investors determine an investment’s return, given its amount of downside deviation, or, bad risk.Investment Tips
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