What Is the Sortino Ratio?
The Sortino ratio is a financial ratio used to measure the risk-adjusted performance of a portfolio or investment. Frank Sortino and Stephen Satchell developed it in 1992. The formula measures the potential return on investment while considering the downside volatility of the returns.
References:
1. Sortino, Frank (1991). “The Sortino Framework for Constructing Portfolios”. Investment Management.
2. Sortino, Frank (2003). “The Sortino Ratio: Differentiating Good Risk from Bad Risk”. Financial Analysts Journal.
3. Jones, Peter (2014). Investment Risk Management. Chichester, West Sussex: Wiley.
How to Calculate the Sortino Ratio
The Sortino ratio is a risk-adjusted return measure that is used to evaluate the performance of an investment or portfolio. It is calculated by subtracting the risk-free rate of return from the portfolio’s return and dividing the result by the downside deviation of the portfolio.
1. Calculate the portfolio’s return by subtracting the starting value from the ending value and dividing it by the starting value.
2. Calculate the risk-free rate of return. A risk-free rate of return is the return an investor earns if they invest in an asset such as a U.S. Treasury bill.
3. Calculate the downside deviation of the portfolio by subtracting the minimum return from the average return and dividing it by the average return.
4. Calculate the Sortino ratio by subtracting the risk-free rate of return from the portfolio’s return and dividing it by the downside deviation of the portfolio.
References:
1. Investopedia. (n.d.). Sortino Ratio. Retrieved April 19, 2021, from https://www.investopedia.com/terms/s/sortinoratio.asp
2. Investing answers. (n.d.). Sortino Ratio. Retrieved April 19, 2021, from https://investinganswers.com/financial-dictionary/investment-strategy/sortino-ratio-1104
Sortino Ratio Formula
The Sortino Ratio formula is as follows: Sortino Ratio = (Average Return – Risk-Free Rate) / Downside Deviation.
Suppose a hedge fund’s portfolio has the following returns in 2021: January (1.0%), February (4.0%), March (8.0%), April 10.0%, May 20.0%, June 25.0%, July 16.0%, August 12.0%, September 5.0%, October 3.0%, November (-2.0%), December 4.0%.
Given the monthly returns data, let us assume that the risk-free rate is 2.5%. We can calculate the Sortino ratio for each month, as follows:
Risk Free Rate (rf) rf 2.5% (0.0250)
If we subtract the risk-free rate from the portfolio return, we are left with:
Excess Return (rp – rf) (1.00 – 0.0250) 0.9850
So, the Sortino ratio for the above example is:
Sortino Ratio (((0.9850) / (0.01)) * 100) 98.50%
Example of How to Use the Sortino Ratio
This metric is useful because it allows us to compare investments across different markets and asset classes. For example, let’s say we’re looking at a stock and its corresponding bond fund. Both funds are expected to perform well during the next 12 months, but the stock fund is expected to outperform the bond fund due to lower volatility.
If the stock fund had a Sortino Ratio of 0.8, then we could conclude that the stock fund has a higher return per unit of volatility than the bond fund.
While the Sortino Ratio is an excellent metric for evaluating investment performance, there are two factors you should consider when using it. First, you need to look at the time frame. If you’re looking at just one year, then you might not be able to see the full picture. Second, you need to consider whether you’re looking at long-term or short-term results.
Using long-term investments allows an individual investor to account for a more accurate ratio of both positive and negative stock returns. If you were to record only the positive stock returns, it would not be a true reflection of an investment.
The second factor involves the liquidity of the assets. A fund can be considered to be less risky if its underlying assets are illiquid.
For example, when investing in publicly traded stocks, the price changes frequently. Hence, they are liquid. When incorporating them into the Sortino ratio, the risk-adjusted return appears favorable, but it isn’t.
When to Use the Sortino Ratio
The Sortino Ratio is a useful tool for investors and portfolio managers to use to measure risk-adjusted returns. The formula is helpful, particularly in comparison to other investments. It is used to measure the return per unit of an investment relative to its downside risk and is for looking to maximize positive returns while minimizing risk exposure. The Sortino Ratio is most effective when comparing investments with similar levels of risk, as it considers only downside risk, not overall market risk.
References:
1. Investopedia (2020). Sortino Ratio. Available at: https://www.investopedia.com/terms/s/sortinoratio.asp
2. Investopedia (2020). What is the Sortino Ratio? Available at: https://www.investopedia.com/ask/answers/040115/what-sortino-ratio.asp
3. Quantopian (2020). What is the Sortino Ratio? Available at: https://www.quantopian.com/posts/what-is-the-sortino-ratio
FAQ
What is a good Sortino Ratio?
The Sortino ratio is a risk-adjusted return measure that takes into account the downside risk of an investment. Generally, a Sortino ratio of 1.0 or higher is considered good, while a ratio of 1.5 or higher is considered excellent.
Is a higher Sortino Ratio better?
Yes, a higher Sortino Ratio is better. A higher Sortino ratio indicates that investment has generated higher returns for a given level of risk.
Is the Sortino Ratio better than Sharpe Ratio?
It is often considered better than the Sharpe ratio because this calculation takes into account the downside risks. This allows investors to measure the risk-adjusted performance of investments while still considering the potential for losses.
