Using the Sortino Ratio to Gauge Downside Risk

June 27, 2024 Beginner
The Sortino ratio focuses only on the downside risk of a portfolio, which is what short-term investors may want if they've got a short-term goal. The higher the Sortino ratio, the better the risk-adjusted return.

You're investing part of your savings over the next three years for a downpayment on a home or possibly your child's first year of college. The right investments can help you meet your goals faster—but you realize you can't take the risk of significant market losses setting you back.

How can you tell if an investment you're looking at has a track record of avoiding downside volatility, better known as potential losses?

The Sortino ratio, named for economist Frank Sortino and his investment work in the early 1980s, may help guide you in the right direction. This particular formula only uses annual downside volatility of the investment in its calculation, giving you a potentially clearer picture of an investment or a portfolio's risk-adjusted return.

If you have a relatively short investment time horizon (say three years), downside risk is all the more important to your investment decisions. The Sortino ratio can help you measure this exposure, so you know how much risk you're potentially taking on. Remember, though, as with most market calculations, the Sortino ratio uses historical data to produce a result. Past performance is no guarantee of future results.

What is the Sortino ratio?

The Sortino ratio is one of three key metrics of risk-adjusted performance used by professional portfolio managers; the other two metrics are the Sharpe ratio and the Information ratio.

The Sortino ratio is a variation on the Sharpe ratio. While the Sharpe ratio measures excess returns against total volatility (gains and losses), the Sortino ratio is built to focus on weighing the potential for downside risk.

According to Viraj Desai, director of Schwab Asset Management, "You'll see the Sortino ratio most frequently used by investors who have a very low risk tolerance and a generally short investment time horizon—less than three years, for example. Those with longer-term investment time horizons may bypass the Sortino ratio and focus on the Sharpe or Information ratios for a broader idea of upside and downside risk. But in short-term investment situations where goals are near, investors would do well to pay closer attention to the Sortino ratio."

How to calculate the Sortino ratio

The Sortino ratio begins with an investor's desired return they want to beat based on their risk tolerance and investment time horizon.

For example, investors may choose from a range of variables to plug in to the equation, including major stock indexes like the S&P 500® (SPX), a specific U.S. Treasury rate (the lower risk rate), or in the case of some professional portfolio managers, a client-specified return referred to as the minimal acceptable return (MAR) they need to meet or beat.

For uniformity's sake, we'll make the lower risk rate in the equation the 10-year Treasury note (TNX) yielding about 4.20% as of early March 2024. 

Here's how that equation would look.

Sortino ratio = (Rp – Rf) ÷ Downside deviation

Key:

  • Rp: Investment return (actual or forecast)—this is the investment's current annual return, and you'll find it in the fund's fact sheet or prospectus.
  • Rf: Risk-free rate—the low-risk rate of return you hope to beat, usually a U.S. Treasury yield. (Though Desai pointed out that investors can elect to use their own measure for that return, such as a MAR.)
  • Downside deviation: This is a measure of the investment's downside volatility or losses. A lower standard deviation implies less risk and consequently a higher Sortino ratio. A higher standard deviation implies more risk and a lower Sortino ratio. You'll typically find this data in the investment's fact sheet or prospectus. 

What's a good Sortino ratio?

The Sortino ratio gives investors an idea of how much risk they could face over time based on historical data. The higher the Sortino ratio, the better the return for the amount of risk taken on: 

  • Less than 0 is considered not acceptable for inclusion in one's investments.
  • 0.00 – 1.00 is considered suboptimal. 
  • Above 1.00 is considered good.
  • Above 2.00 is considered very good.
  • Above 3.00 is considered excellent.

A tale of two investments

Now that we have the equation and what the Sortino ratio can mean, let's lay it out with a hypothetical comparison of two mutual funds you may have your eye on as potential investments.

Mutual Fund A

  • Estimated 12-month return: 15%
  • Risk-free rate: 3.75%
  • Downside standard deviation: 18% 
  • The calculation: (0.15 – .0375) ÷ 0.18 = Sortino ratio of 0.625

Mutual Fund B

  • Estimated 12-month return: 14%
  • Risk-free rate: 3.75%
  • Downside standard deviation: 6% 
  • The calculation: (0.14 – .0375) ÷ 0.06 = Sortino ratio of 1.71

While both mutual funds have similar returns, Mutual Fund A has taken on far more risk (as seen in the 18% downside standard deviation) to achieve its return. 

Mutual Fund B, on the other hand, has a significantly lower downside standard deviation (6%), meaning it's taking on less risk to produce a very similar return. 

As a result, Mutual Fund A should be avoided because of its low Sortino ratio—too much risk for the reward, while Mutual Fund B has an acceptable (almost very good) Sortino ratio. Mutual Fund B's relatively high Sortino ratio could make it a viable candidate for inclusion in your portfolio.

Now that we have the equation and what the Sortino ratio can mean, let's lay it out with a hypothetical comparison of two mutual funds you may have your eye on as potential investments.

Mutual Fund A

  • Estimated 12-month return: 15%
  • Risk-free rate: 3.75%
  • Downside standard deviation: 18% 
  • The calculation: (0.15 – .0375) ÷ 0.18 = Sortino ratio of 0.625

Mutual Fund B

  • Estimated 12-month return: 14%
  • Risk-free rate: 3.75%
  • Downside standard deviation: 6% 
  • The calculation: (0.14 – .0375) ÷ 0.06 = Sortino ratio of 1.71

While both mutual funds have similar returns, Mutual Fund A has taken on far more risk (as seen in the 18% downside standard deviation) to achieve its return. 

Mutual Fund B, on the other hand, has a significantly lower downside standard deviation (6%), meaning it's taking on less risk to produce a very similar return. 

As a result, Mutual Fund A should be avoided because of its low Sortino ratio—too much risk for the reward, while Mutual Fund B has an acceptable (almost very good) Sortino ratio. Mutual Fund B's relatively high Sortino ratio could make it a viable candidate for inclusion in your portfolio.

What are the limitations of the Sortino ratio?

As with most any portfolio calculation, the Sortino ratio has limitations investors should be aware of:

  • The Sortino ratio is calculated using historical performance data, which may not hold up in the future. Investors would do well to view the Sortino ratio as a snapshot of that investment's potential loss risk based on the latest market data available. 
  • The Sortino ratio is not recommended for highly volatile investments, sometimes known as alternative investments, including commodities, publicly traded hedge funds, real estate, or some long/short strategies. That's because this ratio does not capture what could be significant upside volatility or gains.
  • Even though the Sortino ratio is seen as a useful barometer for risk-averse investors with short time horizons, most experts note that using less than three years of historic data can weaken the validity of its calculation. "Ten years' worth of data is ideal for the Sortino ratio because it will encompass an entire business cycle," Desai explained.

Bottom line

Combined with the other two risk-adjusted metrics (Sharpe ratio and Information ratio), the Sortino ratio focuses on the downside risk profile of an asset over time. The Sortino ratio can be especially useful for investors with a low risk tolerance or a short-term investing time horizon, so they will want to pay closer attention to the fund's Sortino ratio than a long-term investor might.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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