Sortino Ratio

Sortino Ratio

What it is

The Sortino ratio measures risk-adjusted return while penalizing only downside (harmful) volatility. Unlike the Sharpe ratio, which uses total return volatility, the Sortino ratio focuses on negative deviations from a chosen target (commonly the risk-free rate or a minimum acceptable return). A higher Sortino ratio indicates more return per unit of downside risk.

Formula and calculation

Sortino Ratio = (Rp − r) / σd

Where:
* Rp = actual or expected portfolio return
* r = target return (often the risk-free rate)
* σd = downside deviation (standard deviation of returns below the target)

Downside deviation is calculated from returns that fall below the target:
σd = sqrt( (1/N) * Σ (target − ri)^2 ) for all i where ri < target

Notes:
* Ensure consistency in the return type and period (e.g., annualized returns and annualized downside deviation).
* The numerator commonly uses the risk-free rate, but you can substitute a minimum acceptable return or an expected return depending on your objective.

Interpreting the ratio

• Higher is better — it means the portfolio earns more excess return per unit of downside risk.
• Values are unitless and best used to compare similar investments or strategies.
• Because Sortino ignores upside volatility, it is preferable when positive volatility should not be treated as a penalty.

Example

Compare two mutual funds with a risk-free rate of 2.5%:

Mutual Fund X
* Annual return: 12%
* Downside deviation: 10%
* Sortino = (12% − 2.5%) / 10% = 0.95

Mutual Fund Z
* Annual return: 10%
* Downside deviation: 7%
* Sortino = (10% − 2.5%) / 7% ≈ 1.07

Although Fund X has a higher raw return, Fund Z has a higher Sortino ratio, meaning Z delivers better return per unit of downside risk and would be preferred by an investor focused on downside protection.

Key considerations and limitations

• Choice of target matters: using the risk-free rate, a minimum acceptable return, or an expected return changes the result.
• Sortino addresses the downside-only risk preference but ignores total volatility; for some investors, total volatility is still relevant.
• Comparisons are most meaningful among similar asset classes and return measurement periods.
• Use Sortino alongside other metrics (Sharpe, drawdown, alpha) for a fuller view of risk and return.

Bottom line

The Sortino ratio refines risk-adjusted performance measurement by isolating negative volatility. It better reflects investor preferences when upside volatility is beneficial. Choose the Sortino ratio when your primary concern is downside risk, but combine it with other measures to inform allocation and selection decisions.