The Sortino ratio is a risk-adjusted performance measure used to evaluate the return of an investment portfolio or an individual security relative to its downside risk. It is similar to the Sharpe ratio but focuses only on the volatility of returns below a specified target or minimum acceptable return, rather than the total volatility of returns.
The Sortino ratio was developed by Frank A. Sortino and is designed to help investors better evaluate investments that have a higher probability of incurring losses. It measures the excess return of an investment over the minimum acceptable return (or target return) divided by the downside deviation of the investment's returns. Downside deviation is a measure of volatility that only considers returns below the minimum acceptable return.
A higher Sortino ratio indicates better risk-adjusted returns, specifically in relation to the downside risk.
Imagine there are two investment opportunities: Fund A and Fund B. Fund A has an annual return of 12% with a minimum acceptable return of 6% and a downside deviation of 10%, and Fund B has an annual return of 10% with a minimum acceptable return of 5% and a downside deviation of 8%.
To calculate the Sortino ratio for each fund, we subtract the minimum acceptable return from the fund's annual return and then divide by the downside deviation of the fund's returns. For Fund A, the Sortino ratio would be (12% - 6%) / 10% = 0.60. For Fund B, the Sortino ratio would be (10% - 5%) / 8% = 0.625.
In this example, Fund B has a higher Sortino ratio, indicating that it provides better risk-adjusted returns in relation to downside risk than Fund A. Although Fund A has a higher annual return, it also has a higher downside deviation, indicating higher downside risk, which negatively impacts its Sortino ratio.