Sortino Ratio: What it is and what it is for

What is the Sortino ratio

The Sortino ratio activity is a variation of the sharpe-ratio. This ratio Differentiate harmful volatility from global volatility using the asset standard deviation of the negative portfolio return (downward deviation) instead of the total standard deviation of the portfolio return. The Sortino ratio takes the profitability of an asset or portfolio, subtracts the risk-free rate, and then divide that amount by the downward deviation of the asset. The ratio is named after Frank A. Sortino.

What is the Sortino ratio for?

The Sortino ratio is a useful way for investors, analysts and portfolio managers to evaluate the profitability of an investment for a given level of bad risk. Since this ratio uses only the downward deviation as a measure of risk, it solves the problem of using the total risk, or standard deviation, which It is important because upward volatility is beneficial for investors and it is not a factor that worries most of them.

graph 1

Comparison of the Sortino ratio of the Van Eck Gold ETF (GDX) compared to its competitors. Source: Macro Axis.

How the Sortino ratio differs from the Sharpe ratio

The Sortino ratio improves the Sharpe ratio by isolating downward or negative volatility from total volatility dividing the excess return by the downward deviation rather than by the total standard deviation of a portfolio or asset. The Sharpe ratio does not favor investment due to good risk, which provides positive returns to investors. However, It is necessary to determine which ratio to use depending on whether the investor wants to focus on the total deviation or the standard deviation., or only in the downward deviation.

How the Sortino ratio is calculated

Because the Sortino ratio focuses only on the negative deviation of a portfolio's return from the mean, is believed to provide a better view of a portfolio's risk-adjusted returns, as positive volatility is a benefit. The Sortino index It differs from the Sharpe ratio in that it only considers the standard deviation of the downside risk, instead of total risk (upside + downside).

1 formula

Formula for calculating the Sortino ratio.

Example of use of the Sortino ratio

Like the Sharpe ratio, a higher Sortino ratio result is better. When examining two similar investments, an investor will prefer the one with the highest Sortino ratio, because it means that the investment is generating more profitability per unit of the bad risk it assumes. For example, let's say ETF A has an annualized return of 12% and a downside deviation of 10%. On the other hand, we have an ETF B that has an annualized return of 10% and a downward deviation of 7%. The risk-free rate is 2,5%. The Sortino ratios of both ETFs would be calculated as follows:

2 formula

Calculations of the Sortino ratio of the given example.

Although ETF A generates 2% more annualized returns, it is not earning that return as efficiently as ETF B due to its downward deviations. According to this metric, ETF B is the best investment option. Although it is common to use the risk-free rate, investors can also use the expected return in the calculations. For the formulas to be accurate, the investor must be consistent in the type of return they are looking for..

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