Sortino Ratio

In finance, ratios are used to evaluate the performance of investment portfolios, mutual funds, or individual securities. One such ratio is the Sortino Ratio, which measures the risk-adjusted return of an investment, taking into account only downside risk. It is named after its creator, Frank A. Sortino, who introduced it in 1980.

What is Sortino Ratio?

The Sortino Ratio is a risk-adjusted performance measure that focuses only on the downside risk of an investment. It is calculated by dividing the excess return of an investment over a specified risk-free rate by the investment’s downside deviation. The formula for the Sortino Ratio is as follows:

Sortino Ratio = (Rp – Rf) / Dd

Where:

• Rp = Expected Portfolio Return
• Rf = Risk-Free Rate of Return
• Dd = Downside Deviation of Portfolio Returns

To better understand the Sortino Ratio, let’s break down its components:

• Expected Portfolio Return (Rp): This is the expected return that an investor can expect to earn from their investment. It is calculated based on the historical performance of the investment, taking into account the asset allocation and investment strategy.
• Risk-Free Rate of Return (Rf): This is the theoretical rate of return that an investor could earn on a risk-free investment, such as a government bond or a treasury bill. It is used as a benchmark to measure the performance of an investment portfolio.
• Downside Deviation (Dd): This is a measure of the volatility of an investment’s returns, but only for returns that fall below a specified minimum threshold, known as the minimum acceptable return (MAR). The MAR is typically set to zero, meaning only negative returns are considered when calculating downside deviation.

Why is Sortino Ratio important?

The Sortino Ratio is a valuable measure of an investment’s risk-adjusted return, focusing only on downside risk. This makes it particularly useful for risk-averse investors who want to minimize their exposure to losses. It can be used to compare the performance of different investment portfolios or to evaluate the performance of a single portfolio over time.

Limitations of Sortino Ratio

Like any ratio, the Sortino Ratio has its limitations, which include:

• It only considers downside risk, which may not be a complete picture of an investment’s risk profile.
• It assumes that returns are normally distributed, which may not always be the case in real-world scenarios.
• It does not take into account the size of the loss, only the frequency of losses.

What is a Good Sortino Ratio?

A good Sortino Ratio depends on the investor’s risk profile, investment objectives, and the nature of the investment. Generally, a higher Sortino Ratio indicates a better risk-adjusted return, as it means that the investment is generating more return per unit of downside risk. However, what constitutes a good Sortino Ratio varies depending on the investment context.

For example, a conservative investor who prioritizes capital preservation over return may consider a Sortino Ratio of 1 or higher as good. On the other hand, an aggressive investor willing to take on higher levels of risk may consider a Sortino Ratio of 2 or higher as good.

Additionally, the nature of the investment can affect what constitutes a good Sortino Ratio. For example, an investment in a stable, low-volatility asset such as a government bond may have a lower Sortino Ratio but still be considered good, as it generates a steady, predictable return with minimal downside risk.

Conclusion

The Sortino Ratio is a valuable tool for investors looking to evaluate the risk-adjusted return of an investment. Focusing only on downside risk provides a more complete picture of an investment’s performance, particularly for risk-averse investors. However, like any ratio, it has its limitations and should be used in conjunction with other measures to fully evaluate an investment’s risk profile.