What is Sortino Ratio?
Understanding the Sortino Ratio and why it matters for evaluating downside risk-adjusted investment returns
Table of Contents
1Definition of Sortino Ratio
Sortino Ratio is a variation of the Sharpe ratio that differentiates harmful volatility from total overall volatility by using the asset's downside deviation rather than standard deviation.
Named after Frank A. Sortino, this ratio focuses exclusively on the negative deviation of a portfolio's returns from the mean, thereby measuring the risk-adjusted return with respect to downside risk. It recognizes that upside volatility is beneficial to investors and should not be penalized in the risk calculation.
The Sortino ratio provides a more accurate view of risk-adjusted performance for investments with non-normal return distributions or when downside protection is a primary concern.
2The Sortino Ratio Formula
The formula for calculating the Sortino Ratio is:
The downside deviation is calculated by taking only the negative deviations from the target return (usually the risk-free rate or zero) and finding their standard deviation. This means only returns that fall below the target are considered risky.
3Example Calculation
Sortino Ratio Example
Let's say we have a portfolio with an expected return of 15% and a downside deviation of 8%. The risk-free rate is 3%.
Using the Sortino Ratio formula: (15% - 3%) / 8% = 12% / 8% = 1.5
This means the portfolio earns 1.5 units of excess return for each unit of downside risk. Generally, a higher Sortino ratio indicates better risk-adjusted performance, with values above 2 typically considered good.
4Why Sortino Ratio Matters
Focuses on Harmful Risk
The Sortino ratio distinguishes between good and bad volatility, penalizing only the downside movements that investors aim to avoid.
Non-Normal Distributions
It's particularly useful for evaluating investments with asymmetric or skewed return distributions where upside potential exceeds downside risk.
Risk Management
The Sortino ratio helps investors identify strategies that minimize losses while maximizing returns, aligning with most investors' actual risk preferences.
Alternative Perspective
It provides an additional lens for performance evaluation, complementing other risk-adjusted metrics like the Sharpe ratio for more comprehensive analysis.
5Limitations of Sortino Ratio
While the Sortino ratio offers several advantages, it also has limitations:
- Data Requirements: Calculating downside deviation accurately requires sufficient historical data points, which may not always be available.
- Subjective Target Return: The choice of target return (minimum acceptable return) can significantly impact the ratio calculation and introduce subjectivity.
- Backward-Looking: Like many performance metrics, the Sortino ratio is calculated based on historical data and may not accurately predict future performance.
- Ignores Higher Moments: While it improves upon the Sharpe ratio by focusing on downside risk, it still doesn't account for other aspects of the return distribution like kurtosis (tail risk).