Sortino Ratio is a financial metric used to measure the risk-adjusted return of an investment, similar to the Sharpe Ratio. However, unlike the Sharpe Ratio, the Sortino Ratio only considers downside risk, making it a more precise tool for evaluating investments where investors are primarily concerned with losses.
Definition
The Sortino Ratio is calculated as:
- Sortino Ratio = (Rp - Rf) / σd
where:
- Rp – Return of the portfolio.
- Rf – Risk-free rate (e.g., U.S. Treasury rate).
- σd – Downside deviation (standard deviation of negative returns).
Interpretation
- Sortino Ratio > 1.0 – Indicates strong risk-adjusted performance with low downside risk.
- 0 < Sortino Ratio ≤ 1.0 – Suggests moderate performance but with noticeable downside risk.
- Sortino Ratio < 0 – Indicates that the investment underperforms relative to the risk-free rate, meaning higher risk without sufficient return.
Example Calculation
Suppose:
- Portfolio return (Rp) = 12%
- Risk-free rate (Rf) = 3%
- Downside deviation (σd) = 5%
The Sortino Ratio is:
- (12% - 3%) / 5% = 1.8
Advantages
- Focuses on downside risk
- Only penalizes volatility that leads to losses.
- Better than Sharpe Ratio for asymmetrical returns
- More effective for assets with skewed return distributions.
- More relevant for conservative investors
- Provides a clearer risk-adjusted measure for funds aiming to minimize losses.
Limitations
- Requires downside deviation calculation
- More complex than standard deviation used in the Sharpe Ratio.
- Can be misleading for low-volatility assets
- A low-risk asset with low returns may still have a high Sortino Ratio.
- Sensitive to the threshold for downside risk
- Different investors may define "negative returns" differently.
Applications
- Portfolio Management
- Used by fund managers to evaluate performance relative to downside risk.
- Risk-Adjusted Investment Analysis
- Helps investors choose funds or stocks with better downside protection.
- Hedge Funds and Alternative Investments
- Often preferred over the Sharpe Ratio for non-traditional assets.
Comparison with Sharpe Ratio
| Metric | Formula | Risk Considered |
|---|---|---|
| Sharpe Ratio | (Rp - Rf) / σp | Total risk (both upside and downside) |
| Sortino Ratio | (Rp - Rf) / σd | Only downside risk |