Investors constantly seek high returns on their investments, but they also have to consider the risks inherent in various investments.
The Sharpe Ratio is often used to measure returns in relation to volatility or risk. However, the Sortino Ratio is a more sophisticated measure of risk-adjusted return that focuses on downside risk.
This ratio is an important metric that any investor should consider in a comprehensive analysis of an investment.
In this article, we’ll delve into the Sortino Ratio, how it works, and when to use it. You’ll learn crucial insights about the formula for calculation, characteristics, examples, advantages, limitations, and how to interpret the Sortino Ratio.
As you continue reading, you’ll discover why this ratio provides a concise yet comprehensive picture of whether an investor should take on a particular risk inherent in an investment.
What is the Sortino Ratio?
Developed in 1980 by Frank A. Sortino, a professor of finance at San Francisco State University, the Sortino Ratio is a risk-adjusted performance measure that uses downside deviation instead of total deviation in the denominator.
The ratio measures an investment’s excess returns relative to the amount of potential loss or downside risk as measured by the standard deviation of negative returns.
Simply put, the Sortino Ratio evaluates the quality of returns, considering downside risk only, whereas Sharpe Ratio evaluates total risk, both upside and downside.
The basic formula for calculating the Sortino Ratio is:
Sortino Ratio = (R – Target Rate of Return) / Downside Deviation
Where R is the average rate of return, and the target rate of return is the minimum return requirement defined by the investor.
This ratio doesn’t just indicate the amount of return or risk-adjustment, but the consistency of the fund/portfolio in delivering risk-adjusted returns.
How is the Sortino Ratio Calculated?
The calculation of the Sortino Ratio is more accurate than that of the Sharpe Ratio. To understand the formula, we have to know the following terms:
- Return on Investment (R): This is the average rate of return of an investment over a particular period.
- Risk-Free Rate (Rf): This is the required rate of return on a risk or investment that has no risk. Some people use T-bills as the risk-free rate.
- Target Rate of Return (Tr): This represents the minimum or required target rate of return the investor hopes to get from the investment.
- Downside Deviation (DD): This is a measure of the risk that only pertains to negative deviation. It doesn’t include positive deviation.
The formula to calculate the Sortino Ratio is:
Sortino Ratio = (R – Tr) / DD
The Sortino Ratio reveals the amount of return an investor is getting for every unit of risk while still focusing on downside risk.
Real-life Examples and Use Cases
Analysts use the Sortino Ratio to evaluate the risk-adjusted returns of a portfolio, and uncover insights into the portfolio’s potential that another ratio wouldn’t have highlighted.
For example, assume a mutual fund has a five-year average return of 10%, a downside deviation of 5%, and a target rate of return of 4%.
It would be able to reduce losses in the negative deviation period, reducing downside risk. The Sortino Ratio for this mutual fund as calculated above would be 1.2.
Another practical use of the Sortino Ratio is that investors can compare their fund with another that has a similar downside deviation, calculate both ratios of the funds, and see which investment gives a better risk-adjusted return.
The Sortino Ratio can also be used to determine how well a portfolio manager or adviser is performing in terms of risk management.
An adviser that creates a portfolio with high Sortino Ratio can be assumed to be offering a lower overall risk for clients, thus resulting in a long-term sustainable performance.
Advantages of using the Sortino Ratio
It’s a better indicator of risk quality
The Sortino Ratio provides a more accurate assessment of the downside risk inherent in an investment portfolio.
Unlike the Sharpe Ratio, which uses total deviation, the Sortino Ratio utilizes just the downside deviation to measure risk.
By assessing the downside risk, investors can get a more precise picture of how well a portfolio is performing in negative market conditions.
Considers consistency
The Sortino Ratio focuses on the consistency of returns by incorporating the downside deviation in the calculation.
It provides investors with insights into a portfolio’s consistency in delivering risk-adjusted returns, which is an essential factor in long-term sustainable performance.
Appropriate for risk assets
The Sortino Ratio is suitable for measuring the risk-adjusted return of low risk assets like Treasury bills and bonds as well as higher risk assets like equities.
Helps make necessary adjustments
The Sortino Ratio can provide a more granular understanding of where a fund’s portfolio manager should make necessary adjustments, including asset allocation and rebalancing.
Limitations of the Sortino Ratio
Oversimplified
The simplicity of the Sortino Ratio limits its use in complex financial models.
It does not take into account market reward and may fail to perform as required in situations where investment deposits are held in risk-free assets like Treasury bills during periods of investment.
Lacks a standard value for comparison
Unlike the Sharpe Ratio, the Sortino Ratio leaves investors without an appropriate standard to evaluate the results.
Not a complete measure
The Sortino Ratio only assesses downside deviation when measuring the risk-adjusted performance of a portfolio.
Therefore, it can’t fully replace other measures such as the Sharpe Ratio or the Treynor Ratio, which provide a more comprehensive view of risk and return.
How to Interpret the Sortino Ratio
Investors should consider several factors when interpreting the Sortino Ratio to make informed decisions about their investment portfolios.
Know the benchmark
Every investor should establish their benchmark for each investment they choose to buy.
They should compare how the fund did to their expectation and benchmark within the same sector.
This approach provides a comprehensive view of how the portfolio performed relative to its peers in the same asset class.
Corresponding time frame
Investors should ensure they compare funds with similar durations to get accurate results.
It’s necessary to compare similar durations for all investments to truly evaluate the portfolio performance.
Future adjustments
Investors take the results from the Sortino Ratio and make the necessary adjustments required to provide enough information so that they can make the right decision on the investment.
By analyzing and assessing the portfolio using the Sortino Ratio, investors can adjust their portfolios accordingly by reallocating assets or rebalancing the portfolio.
Interpretation of Sortino Ratio results
A Sortino Ratio of more than one indicates a consistently strong performance during negative market times, while a Sortino Ratio of less than one may indicate that the Investments are not worth the risk taken.
For example, in a volatile market, a fund with a high Sortino Ratio may be more attractive than one with a low Sortino Ratio.
Likewise, a portfolio that consistently performs poorly in negative market conditions may have a low Sortino Ratio, indicating it might not be a worthwhile investment.
Frequently Asked Questions (FAQs)
What is a good Sortino Ratio?
A good Sortino Ratio is greater than 1.
Which is better, Sortino Ratio or Sharpe Ratio?
The two ratios excel in different areas, and it depends on the investor’s preferences. The Sharpe Ratio considers both upside and downside volatility, while the Sortino Ratio only considers downside risk.
What does a high Sortino Ratio mean?
A high Sortino Ratio suggests that the investor is getting a low risk of downside along with attractive returns.
Conclusion
The Sortino Ratio is one of the leading risk-adjusted performance measures for analyzing investment performance quality.
It also helps to minimize the impact of downside risk, providing investors with an accurate and more precise measure of a fund’s true risk-adjusted performance.
It’s essential for investors to understand how to calculate and use the Sortino Ratio to make informed decisions about their portfolios.
It’s a reliable metric that every investor should consider as it paints a more insightful and comprehensive picture of whether to take on a given risk inherent in an investment.
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