Using the Sortino Ratio to Gauge Downside Risk
When investing for short-term goals, like a down payment on a home, investors are often less able to absorb significant market losses. As a result, they tend to look for funds with a history of low downside volatility (and therefore, lower risk). That can be easier said than done, but the Sortino ratio may be able to help.
What is the Sortino ratio?
Developed by finance professor Frank Sortino in the early 1980s, the Sortino ratio is a specialized, risk-adjusted performance metric that measures a fund's excess return (its return above a target or risk-free rate) relative to its downside risk. It's one of three key measures of risk-adjusted performance commonly used by professional portfolio managers—the others being the Sharpe ratio and the information ratio.
A variation of the Sharpe ratio, which measures excess returns against total volatility (gains and losses), the Sortino ratio focuses exclusively on downside volatility by using a metric called downside deviation. This ratio provides a way for investors to quickly gauge the excess return a fund produces for each unit of downside risk it takes on.
"The Sortino ratio is most frequently used by investors who have a very low risk tolerance and a generally short investment time horizon," said Viraj Desai, director of Schwab Asset Management. "Those with longer-term investment time horizons may focus on the Sharpe or information ratios for a broader idea of upside and downside risk."
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How to calculate the Sortino ratio
The most common way to calculate the Sortino ratio is to subtract the risk-free rate from a fund's actual or expected return and then divide by the downside deviation.
However, Frank Sortino's original formula used a minimum acceptable return (MAR)—a required rate of return for the investment strategy under consideration—in place of the risk-free rate.
Here's the formula for the Sortino ratio:
Sortino ratio = (Rp – Rf) ÷ downside deviation
Key:
- Rp: Investment return (actual or forecast)—this is the investment's expected or current annual return, which can be found in a fund's fact sheet or prospectus.
- Rf: Risk-free rate—the low-risk rate of return a fund attempts to exceed, usually a U.S. Treasury yield. However, investors may opt to select their own benchmark, such as a MAR.
- Downside deviation: Downside deviation measures the volatility of the fund's returns that fall below a specific target, like the risk-free rate or MAR. Lower downside deviation implies less risk, while higher downside deviation implies more risk.
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 relative to the risk taken on. Here are guideline ranges to consider when evaluating the Sortino ratio:
- Less than 0 indicates an investment's return is lower than either the risk-free rate or the MAR.
- 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.
Limitations of the Sortino ratio
As with most risk-adjusted return metrics, the Sortino ratio has limitations:
- The Sortino ratio is based on historical performance data, which may not hold up in the future. Investors should consider viewing the Sortino ratio as a snapshot of an investment's potential risk based on the latest available market data.
- The Sortino ratio is not recommended for highly volatile investments, such as alternative investments, commodities, publicly traded hedge funds, real estate, or some long/short strategies. This is because it does not capture potentially significant upside volatility.
- Using less than three years of historical data can weaken the validity of Sortino ratio calculations. "Ten years' worth of data is ideal for the Sortino ratio because it will, in most cases, encompass an entire business cycle," Desai said.
Bottom line: Gauging downside risk
The Sortino ratio can help investors measure the risk-adjusted returns of a fund or portfolio. Because it focuses on downside risk, it can be especially useful for investors with a low risk tolerance or a short-term investment horizon.
However, like all financial metrics, the Sortino ratio should be viewed as only a starting point for further analysis. Before investing in any fund, investors should research not only historical performance but also fees, tax implications, and more. Focusing on these foundational elements can help determine whether a fund aligns with an investor's goals and risk tolerance.
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This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned are not suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decisions.
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