What is the Sortino ratio?
The Sortino ratio is a financial calculation that enables traders and investors to determine the risk-adjusted performance of their portfolios, strategies, or investments. Put differently, it is a risk-adjusted statistic utilised to quantify risk to reward.
Contrary to another risk-adjusted statistic, the Sharpe ratio, the Sortino ratio takes into consideration only downside deviation (downside volatility), excluding the impact of upside volatility.
It was named after Frank Sortino, an economist and finance professor emeritus from San Francisco State University.
What is the difference between the Sortino ratio and the Sharpe ratio?
The Sharpe ratio was created by the American economist William Sharpe in 1966. It is probably the most commonly used risk-adjusted ratio by investors and traders to gauge the performance of an investment by adjusting for its risk.
The Sharpe ratio differs from the Sortino ratio in that it uses standard deviation (both downward and upward volatility) in its calculation.
Furthermore, the Sortino ratio is used to evaluate investment portfolios with high volatility. The Sharpe ratio is utilised to appraise investment portfolios that are low on volatility.
With regard to the significance of the outcome:
- The Sortino ratio – a ratio that is either one or higher is regarded as a risk-adjusted return of earnings.
- The Sharpe ratio – a negative ratio indicates that an investor will secure a better risk-adjusted rate of earnings by making use of a risk-free option.
Which one is the more efficient ratio?
Many financial analysts, investors, and traders prefer the Sortino ratio, arguing it is a more efficient measure of risk and return because it only takes downside volatility into consideration when it determines risk. Proponents of the Sortino ratio say upward volatility is what investors and traders should look to target and should not be seen as negative.
Sortino ratio formula
In layman’s terms, the formula for the Sortino ratio looks like this:
Sortino ratio = Expected return – Risk-free rate of return/Downside deviation.
The expected return, also known as average realised return, of a portfolio or investment is measured over a certain period of time. This can be the actual returns for the portfolio or investment or the expected future return.
The risk-free rate of return, also referred to as the required rate of return, is the return that can be expected from taking on zero risk.
Downside deviations are also referred to as the standard deviation of negative asset returns, implying that the downside deviations are measured by taking the standard deviation of only the negative returns observed over a specific period of time.
Example of a Sortino ratio calculation
Let us assume we have an investment with the following monthly returns for a period of 10 months:
15%, 4%, -6%, 1%, 10%, 15%, 3%, -2%, -5%, and 7%
Step 1
Calculate the average monthly return by dividing the sum of the returns by the number of returns.
Average monthly return: 42%/10 = 4.2%
Let us say the target return is the expected monthly return of an index on a stock exchange, for example, 3.5%.
Thus, the excess return is 0.07% (4.2% – 3.5%).
Step 2
Calculate the downside deviations. We take only into account the negative values, which are -6%, -2%, and -5%, because the Sortino ratio excludes the upside deviations.
Step 3
Square the negative values.
-6%^2 = .0036
-2%^2 = .0004
-5%^2 = .0025
Determine the average of the downside deviations by dividing the sum by the number of returns:
.0036 + .0004 + .0025 = .0065
.0065/10 = .00065 = .065%
Step 4
Calculate the target downside deviation, which is the square root of the answer in step 3.
√.00065 = .0255
Step 5
Lastly, calculate the Sortino ratio by dividing the excess return (refer answer in step 1) by the target downside deviation (refer step 4).
.007/.0255 = 0.275
What is a good Sortino ratio?
A higher Sortino ratio is better than a lower one because it is an indication that the particular portfolio or investment is operating effectively without unnecessary risk that is not being rewarded in the form of higher rewards.
A low or negative Sortino ratio may signal that the investor has not benefitted from taking on additional risk.
The higher the Sortino ratio, the better. Generally, a ratio higher than 2 is considered to be good. However, it is important to keep in mind the asset class under consideration when analysing Sortino ratios.
However, it is important to evaluate risk and returns over a number of years to get a true picture of the risk and return profile of a portfolio, investment, or strategy.
Limitations of the Sortino ratio
- Since the Sortino ratio uses the downside deviation method to measure risk, any limitations of downside deviation are transferred to the Sortino ratio, influencing it significantly.
- With downside deviation, there must be enough ‘bad’ risks observations to begin with in order for the calculation of the Sortino ratio to be statistically significant.
- It is subject to manipulation. Just as with the Sharpe ratio, the Sortino ratio can be manipulated through the use of derivatives, attaining artificially high values.
- The most fundamental objection against all the measures of risk-adjusted returns or performances, such as the Sortino ratio and the Sharpe ratio, is that they incorporate only the historical risk.
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