Sortino ratio

    What is the Sortino ratio?

    This ratio is used to measure the level of risk in a portfolio. The higher the Sortino ratio, the better a portfolio has performed relative to the risk taken. It is often used to compare the risk taken between different portfolios to achieve a certain return.

    It is necessary to ground the Sortino ratio into context by comparing a fund’s Sortino ratio with that of another fundindex, or category to determine whether a Sortino ratio is high or low.

    For example, comparing the 10-year Sortino ratios of two (fictional) funds in the same category – Alpha Growth and Beta Value – reveals that the latter, with a ratio of 1.24, has generated a significantly higher return given its downside volatility than did the former, which had a Sortino ratio of 0.96.

    The Sortino ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk.

    Sortino vs. Sharpe ratio

    The Sortino ratio is similar to the Sharpe ratio, however, it uses a different method of calculation. It uses downside deviation at the denominator instead of standard deviation. This is because the standard deviation does not discriminate between up and down volatility.

    By utilising this value, the Sortino ratio only penalises for “harmful” volatility. The Sortino ratio discards any upside deviation – the “excessive” profit. It asks the investor to set a minimum acceptable rate of return (MAR), which is a return that he/she would be comfortable with. Any return above the MAR is not included for the purpose of calculating the Sortino Ratio.

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    The formula for the Sortino ratio

    The ratio was developed by Frank A. Sortino. It is calculated by:

    • Subtracting the risk-free interest rate – for instance, the one given by the 10-year US Treasury bond – from the rate of return of a portfolio;
    • Dividing the result by the downside deviation of the portfolio returns (note that this is different from the standard deviation used in the Sharpe ratio).

    The formula is as follows:

    Sortino ratio = (Rp – Rf) / σd

    Rp = expected portfolio returns

    Rf = risk-free interest rate

    σd = downside deviation of the portfolio

    How to use the Sortino ratio

    Funds that cite the Sortino ratio are usually those with the least tolerance for risk. In these cases, the Sortino ratio may be presented as a compliment to an investment strategy that is risk-averse. This ratio allows investors to assess risk in a focused manner than simply looking at excess returns to total volatility.

    Only when you compare one portfolio’s Sortino ratio with that of another portfolio do you get a feel for its risk-adjusted return. When used in conjunction with other measures, the Sortino ratio can help investors develop a strategy that matches both their return needs and risk tolerance.