Sortino Ratio (SR) measures the risk-adjusted returns of a given scheme. This ratio is suited well to conservative retail investors. In short, SR gives a clear picture of how successfully a scheme’s fund manager has been able to cap downside volatility of a scheme — its returns falling below average returns, and put up encouraging returns.
This makes sense for retail investors as they are more concerned about downside risks of their investments. A key aspect of sortino ratio is it specifically focuses on downside volatility of a scheme.
Meaning : Sortino Ratio
- Sortino ratio (SR) is the statistical tool that measures the performance of the investment relative to the downward deviation.
- It adjusts an investment’s return for risk by looking at potential losses. The ratio measures the true performance of the investment without the influences of upside volatility.
- SR is similar to the Sharpe ratio. Except it uses downside deviation for the denominator instead of Standard Deviation. Standard deviation involves both the upward as well as the downward volatility.
- Investors are only concerned about the downward volatility. SR presents a more realistic picture of the downside risk ingrained in the fund or the stock. The ratio was named after Frank A. Sortino.
- SR is useful for investors and portfolio managers to evaluate an investment’s return for a given level of bad risk. Since SR uses only the downside deviation as its risk measure, it addresses the problem of using total risk. Because upside volatility is beneficial to investors and isn’t a factor most investors worry about.
- Sortino ratio subtracts the risk-free rate of return from the portfolio’s return, and then divides that by the downside deviation.
- Mathematically, it is represented by,
- Sortino Ratio = [ Expected Return – Risk Free Rate of Return ] / Downside Deviation
- SR = [ <R> – Rf ] / SDd
- <R> = Expected Return
- Rf = Risk Free Rate of Return
- SDd = Downside Deviation or Standard Deviation of Negative Asset Return
- Individuals use this calculation to measure the return needed to meet a specific financial goal in the future.
- Investors typically use this figure to measure the risk and performance of investments in a portfolio like mutual funds. SR is also used as a measuring stick for investment managers. Since it tells the excess returns above the investors’ minimum acceptable rate that the manager was able to achieve for the period.
- A higher ratio is always preferred to a lower one. Because it indicates that the portfolio or investment is operating efficiently. And it carries a low risk of a large sudden loss. In this way, it does a better job evaluating the overall risk on an investment than the Sharpe method.
- A large Sortino ratio indicates there is a low probability of a large loss.
- Fom the above example, we can say that even though scheme A has given better returns than scheme B. Still its sortino ratio is less than scheme B.
- This shows that scheme B is a better investment option because it captures better, the downside volatility of a scheme.
sortino ratio v/s Sharpe ratio
- The Sortino ratio and the Sharpe ratio are both risk-adjusted evaluations of return on investment. The Sortino ratio is a variation of the Sharpe ratio that only factors in downside risk.
- It does not penalize a portfolio manager for volatility, and instead focuses on whether returns are negative or below a certain threshold.
- Sharpe ratios are better at analyzing portfolios that have low volatility while Sortino ratio is better when analyzing highly volatile portfolios.
- The choice to use the Sortino or Sharpe methods to evaluate an investment is solely based on whether you want to analyze the total volatility using the standard deviation or the downside volatility using the downside deviation.
- Sortino ratio is the statistical tool that measures the performance of the investment relative to the downward deviation.
- Investors are only concerned about the downward volatility, Sortino ratio presents a more realistic picture of the downside risk ingrained in the fund or the stock. This makes sense for retail investors as they are more concerned about downside risks of their investments.
- Because the Sortino ratio focuses only on the negative deviation of a portfolio’s returns from the mean, it is thought to give a better view of a portfolio’s risk-adjusted performance since positive volatility is a benefit.