What Is Sortino Ratio?
The Sortino ratio is a key metric in portfolio theory that measures the risk-adjusted return of an investment or portfolio. Unlike other risk-adjusted return measures, the Sortino ratio focuses specifically on downside risk, which is the volatility of returns below a predefined threshold, often referred to as the minimum acceptable return (MAR). By isolating only the "bad" volatility, the Sortino ratio aims to provide a clearer picture of an investment's performance from the perspective of an investor who is primarily concerned with protecting against losses and achieving a specific return target. This makes the Sortino ratio particularly relevant for investors with a strong preference for capital preservation or those who are highly risk aversion.
History and Origin
The Sortino ratio was developed by Dr. Frank A. Sortino in the early 1980s as an improvement upon existing risk-adjusted performance measures. Sortino, a finance educator and consultant, sought to create a metric that aligned more closely with investors' actual concerns, which often center on the risk of not achieving their desired returns rather than overall volatility (including upside gains). The first reference to the ratio appeared in Financial Executive Magazine in August 1980, with its initial calculation published in a series of articles in the Journal of Risk Management in September 1981.8 In his early work, the target return was known as the minimum acceptable return (MAR).7 This innovation acknowledged that positive fluctuations are generally beneficial to investors, while negative fluctuations below a certain threshold are what constitute genuine risk for many.
Key Takeaways
- The Sortino ratio measures risk-adjusted return by focusing exclusively on downside volatility.
- It quantifies the excess return generated per unit of downside risk.
- A higher Sortino ratio indicates better performance, as it implies higher returns relative to the risk of falling below a target.
- The ratio requires a user-defined minimum acceptable return (MAR), making it adaptable to individual investor goals.
- It is particularly useful for evaluating investments with non-symmetrical return distributions, such as hedge funds or alternative investments.
Formula and Calculation
The Sortino ratio is calculated using the following formula:
Where:
- $R_p$ = The portfolio's average periodic expected return
- $\text{MAR}$ = The minimum acceptable return or target return (e.g., the risk-free rate, zero, or an investor's specific hurdle rate)
- $\text{Downside Deviation}$ = The standard deviation of returns that fall below the MAR. This is also known as downside volatility.
To calculate the downside deviation, only the returns below the MAR are considered. The squared differences between these returns and the MAR are summed, divided by the number of observations (or observations below MAR), and then the square root is taken.
Interpreting the Sortino Ratio
A higher Sortino ratio indicates that an investment is generating more return for each unit of downside risk taken. Consequently, investors typically prefer investments with higher Sortino ratios. For example, a Sortino ratio of 2.0 means that for every 1% of downside deviation, the portfolio has generated 2% of return above the minimum acceptable return.
When using the Sortino ratio in financial analysis, it's important to compare investments against the same MAR, as changing this threshold will alter the ratio's value. The ratio helps investors differentiate between portfolios that achieve similar returns but with different exposures to undesirable losses.
Hypothetical Example
Consider two hypothetical investment portfolios, Portfolio A and Portfolio B, over a period where the minimum acceptable return (MAR) is 3%.
-
Portfolio A:
- Average Annual Return ($R_p$): 12%
- Downside Deviation: 4%
- Sortino Ratio (Portfolio A) = (12% - 3%) / 4% = 9% / 4% = 2.25
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Portfolio B:
- Average Annual Return ($R_p$): 15%
- Downside Deviation: 8%
- Sortino Ratio (Portfolio B) = (15% - 3%) / 8% = 12% / 8% = 1.50
In this example, despite Portfolio B having a higher average annual return (15% vs. 12%), Portfolio A has a higher Sortino ratio (2.25 vs. 1.50). This indicates that Portfolio A delivered more return for each unit of downside risk it incurred relative to the 3% MAR, making it potentially more appealing for an investor focused on minimizing losses and achieving a consistent investment performance. This analysis can inform asset allocation decisions.
Practical Applications
The Sortino ratio is widely used in portfolio management and investment analysis, particularly for:
- Hedge Fund and Alternative Investment Evaluation: These investments often exhibit non-normal return distributions where positive and negative volatility are not equally undesirable. The Sortino ratio provides a more accurate measure of risk-adjusted returns by only penalizing downside movements.6
- Performance Comparison: Fund managers and investors use the Sortino ratio to compare the effectiveness of different investment strategy in achieving returns above a specific target while controlling negative deviations.
- Risk Budgeting: It helps in understanding the true cost of "bad" risk in relation to the returns generated, assisting in diversification strategies across various asset classes in capital markets.
Limitations and Criticisms
While the Sortino ratio offers a more refined view of risk-adjusted returns by isolating downside risk, it has several limitations:
- Reliance on Historical Data: Like many performance metrics, the Sortino ratio is calculated using past returns, which are not necessarily indicative of future investment performance.5
- Subjectivity of MAR: The choice of the minimum acceptable return (MAR) can be subjective. Different MARs will yield different Sortino ratios, potentially making comparisons inconsistent if not applied uniformly.
- Ignores Upside Potential: By focusing solely on downside volatility, the Sortino ratio does not account for the upside potential or positive volatility that some investors might value.4 Some critics argue that this can lead to an incomplete picture of an investment's risk-return trade-off.3
- Similarities to Sharpe Ratio: Some academic and professional discussions suggest that, in many practical scenarios, the Sortino ratio does not provide significantly different insights compared to the Sharpe ratio, particularly when dealing with long time series.2 The CFA Institute notes that variations in the ratio's calculation can significantly affect the information it conveys, and it is not a complete measure of risk in itself.1
Sortino Ratio vs. Sharpe Ratio
The Sortino ratio is often compared to the Sharpe ratio, another widely used measure of risk-adjusted return. The primary difference lies in how each ratio defines and measures risk.
The Sharpe ratio uses standard deviation to quantify risk, which accounts for both positive and negative volatility equally. This means that large positive deviations from the average return are penalized in the same way as large negative deviations. In contrast, the Sortino ratio distinguishes between these two types of volatility, focusing only on the "bad" downside risk—returns falling below the minimum acceptable return.
For investors primarily concerned with capital preservation and avoiding losses, the Sortino ratio can be a more intuitive and relevant metric. For portfolios with normally distributed returns, the two ratios often provide similar rankings. However, for investments with skewed or non-normal return distributions (common in alternative investments), the Sortino ratio may offer a more accurate assessment of risk relative to an investor's specific loss tolerance.
FAQs
Q: What is a good Sortino ratio?
A: Generally, a higher Sortino ratio is better, indicating more return for each unit of downside risk. While there isn't a universal "good" number, a ratio above 1 is often considered acceptable, and ratios above 2 or 3 are considered very strong, suggesting good protection against losses relative to returns.
Q: Can the Sortino ratio be negative?
A: Yes, the Sortino ratio can be negative if the portfolio's average return is less than the minimum acceptable return (MAR). A negative Sortino ratio indicates that the investment is failing to meet its target return even before accounting for its downside volatility, suggesting poor investment performance.
Q: How does the Sortino ratio help in diversification?
A: The Sortino ratio can help in diversification by enabling investors to select assets or investment strategy that offer favorable risk-adjusted returns, specifically considering their downside exposure. By understanding which assets contribute less to undesirable volatility below a target, investors can construct portfolios that aim to protect capital more effectively.