What is the Sortino Ratio?

Key Takeaways

• The Sortino ratio gauges the risk-adjusted return of an investment portfolio, asset, or strategy, exclusively using the downside risk.

• While the Sortino ratio penalizes only those returns that drop under a certain target or mandatory rate of return, the Sharpe ratio equally punishes upside and downside volatility. 

• It is generally recommended that the Sortino ratio is used not in isolation, but as a complement to other risk metrics and performance measures.   

In investing, especially in high-volatility funds, Sortino ratio is a tool that can be used to measure an investment’s return relative to its bad risk. Investors can use the ratio to size up multiple possible investments.  But what is the Sortino ratio? Here is that and more.

The Sortino Ratio Explained

Named after economist Frank A. Sortino, the Sortino ratio gauges the risk-adjusted return of an investment portfolio, asset, or strategy, exclusively using the downside risk.

The ratio is a modification of the Sharpe ratio, which assesses the performance of a portfolio or security when compared to a risk-free asset after adjusting for risk. While the Sortino ratio penalizes only those returns that drop under a certain target or mandatory rate of return, the Sharpe ratio equally penalizes upside and downside volatility.    

In other words, the portfolio performance tool helps find any additional returns that investors could generate for each unit of market downside risk. With such a clearer picture of possible returns, the investor can make better-informed decisions.

Note that the ratio can be employed to compare differing investment options with disparate risk profiles. Focusing on downside risk permits investors to compare potential investments on an increased equal footing and pinpoint those with better returns for given levels of downside risk.

In addition to retail investors, the ratio is commonly employed by analysts and portfolio managers.

How is Sortino Ratio Calculated?

The calculation of Sortino ratio is:

Sortino Ratio = Actual or Expected Returns on Investment (Rp) – Risk-free Rate (rf)

                         —————————————————————————————

                         Downside Risk Standard Deviation (od)

where R represents the portfolio’s expected value, and r is a risk-free investment’s rate of return.      

For example, consider two disparate investment portfolio schemes, Y and Z, with respective annualized returns of 10% and 15%. Say the downward deviation of Y is 4%, and 12% for Z. In addition, the fixed-deposit risk-free rate is 6%.

For Y, the Sortino ratio calculation (10-6)/4=1. For Z, the ratio is (15-6)/12=0.75.

While Z has a greater annual return than Y, it has a comparatively lesser ratio. The assumption is that investors are more concerned about scheme downside risks than anticipated returns. If that is the case, they will opt for scheme Y since it brings more per-unit return of bad risk and is more likely to skirt a big loss. 

Components of the Sortino Ratio

The Sortino ratio is comprised of components including:

1. Average return. This is the average return generated over a time certain by the investment portfolio.
2. Target return. Set by the investor, the target return is what is called the minimum acceptable return (MAR). It works as a benchmark to measure the holding’s performance.
3. Downside deviation. Also called downside risk, this gauges returns’ variability under the target return. It captures returns that do not make the target, or the risk of negative returns.

Interpreting Sortino Ratio

A higher Sortino ratio indicates a better risk-adjusted performance, all else being equal. The high number represents the degree of return per unit of bad risk. By contrast, a lower ratio means lower returns for each unit of negative risk. If the ratio is negative, that likely means no investor rewards for the risk taken. To be statistically significant, though, there must be sufficient negative volatility events to produce a downward deviation.

Limitations and Considerations

The ratio focuses solely on the downside risk, a fact that generally makes it preferable among investors for calculating risk-adjusted returns. Total volatility would include both upside and downside risks.

Investors tend to be more attuned to downward volatility since they know a positive fluctuation will only mean profits. In this way, focusing on the downside risk takes priority over determining overall market volatility. However, Sortino ratio does assume that downside risk is, for investors, the sole relevant risk.

There are other limitations and considerations, however, including that the ratio is dependent upon target returns. In other words, it does not factor in the specific distribution of returns, rendering it less dependable for investments that have abnormal return distributions. Also, because the Sortino ratio is determined utilizing past data, it is an imperfect indicator of future performance.

Another consideration is the timeframe. It would likely help if investors considered investments made over time, or at minimum those made during an entire business cycle. In doing so, positive and negative stock returns are accounted for. After all, if an investor were to only record positive returns, it would not yield an accurate picture of an investment.

Then there is the assets’ liquidity. While holdings can be construed to demonstrate that they are not as risky, they could be simply because of the illiquidity of the underlying assets being held. For example, because the prices of investments held in companies that are privately owned hardly ever change, they are considered illiquid. Incorporating such prices into the Sortino ratio would make it seem as though the risk-adjusted returns are positive when that is actually not the case. 

Moreover, it is generally recommended that the ratio is used not in isolation, but as a complement to other risk metrics and performance measures. Depending exclusively on the Sortino ratio could result in only a partial measurement of an investment’s risk and return profile. 

Sortino Ratio vs. Sharpe Ratio: What’s the Difference?

The primary difference between the two is that Sortino ratio focuses specifically on the downside risk, while Sharpe ratio factors in overall volatility. In this way, Sortino improves upon the Sharpe tool, which penalizes the investment for good risk, which is what provides positive returns.

For practical purposes, the Sharpe ratio tends to be more appropriate for holdings with low volatility, while the opposite is true for portfolios that have high volatility.

In general, the Sortino ratio is commonly used by investors that seek loftier returns and, thus, use riskier strategies.

Calculating Sortino Ratio in Alternative Investments 

Investors can also use the Sortino Ratio to evaluate the downside risk-adjusted performance of investments or strategies in alternative investments – basically any asset class other than stocks or bonds – such as those offered by the leading alternative investment platform Yieldstreet.

A major benefit of alternatives, other than possible steady passive income, and protection against inflation and volatility, is that they can diversify investor holdings. Financial experts widely agree that portfolio diversification – owning multiple assets that perform differently — is a vital component of a sound investment strategy. 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

While there are limitations, the Sortino metric can help an investor determine an investment’s risk-adjusted returns, relative to the downside risk. Note that the ratio can also be used with alternative investments, which can help diversify portfolios.