Sortino ratio, which is a smarter way of measuring your portfolio performance than the Sharpe ratio. The Sharpe ratio tells you how much extra return you get for every unit of volatility, but it treats all volatility as bad, even when it makes you money. The Sortino ratio only looks at the downside volatility, which is how much your portfolio loses when things go wrong. It then tells you how much excess return you get for every unit of downside risk you take. The higher the Sortino ratio, the better your portfolio is doing. The ratio was named after Frank A. Sortino, a brilliant finance professor who came up with it in the 1980s.
This ratio tells you how much excess return you get for every unit of downside risk you take, which is the volatility of the negative returns. The higher the Sortino ratio, the better your portfolio is doing.
The formula for the Sortino ratio is:
Sortino Ratio = (Rp – rf) / σd where:
- Rp is the actual or expected portfolio return
- rf is the risk-free rate, which is the return you could get by investing in a safe asset like Treasury bills
- σd is the standard deviation of the downside, which is a measure of how much your portfolio returns deviate from the minimum acceptable return (MAR)
To calculate this ratio, you need to have the following data:
- The portfolio returns for a given period, such as monthly or yearly
- The risk-free rate for the same period
- The minimum acceptable return (MAR) for your portfolio, which is the lowest return you are willing to accept
Then, you need to follow these steps:
- Calculate the excess return of your portfolio by subtracting the risk-free rate from the portfolio return
- Calculate the downside deviation of your portfolio by finding the average of the squared differences between the portfolio returns and the MAR, but only for those periods when the portfolio returns are below the MAR
- Take the square root of the downside deviation to get σd
- Divide the excess return by σd to get the Sortino ratio
The Sortino ratio only looks at the standard deviation of the negative risk, or the downside risk, instead of the standard deviation of the whole risk, or the upside and downside risk, like the Sharpe ratio does.
Sortino ratio is thought to give a better picture of a portfolio’s risk-adjusted performance because it only penalizes the negative volatility, which is harmful, and not the positive volatility, which is beneficial.
The Sortino ratio is a helpful way for investors, analysts, and portfolio managers to evaluate how much return an investment generates for a given level of bad risk.
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Example of How to Use the Sortino Ratio
The Sortino ratio, like the Sharpe ratio, is better when higher. For two similar investments, a rational investor would choose the one with the higher Sortino ratio because it shows that the investment has more return per unit of bad risk.
For example, suppose Hedge Fund X has an annualized return of 12% and a downside deviation of 10%. Hedge Fund Z has an annualized return of 10% and a downside deviation of 7%. The risk-free rate is 2.5%. The Sortino ratios for both funds are:
Hedge Fund X Sortino= 10% 12%−2.5%=0.95
HF Z Sortino= 7% 10%−2.5%=1.07
Hedge Fund X has a higher annualized return by 2%, but Hedge Fund Z has a lower downside deviation. Based on this metric, Hedge Fund Z is more efficient in earning returns and is the better investment option.
The risk-free rate of return is commonly used, but investors can also use expected return in calculations. The investor should be consistent in the type of return to keep the formulas accurate.
The Difference Between the Sortino Ratio and the Sharpe Ratio
The Sortino ratio measures the excess return per unit of bad or negative risk by dividing the excess return by the downside deviation, not the total standard deviation of a portfolio or asset.
The Sharpe ratio penalizes the investment for good risk, which gives positive returns to investors. However, the choice of ratio depends on whether the investor wants to focus on total or standard deviation, or only downside deviation.
Before You Go
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