The Sortino ratio, an adaptation of the Sharpe ratio, distinguishes detrimental volatility from overall volatility by focusing on the asset's standard deviation of negative portfolio returns, known as downside deviation, rather than the total standard deviation of portfolio returns.
If you are planning to invest in market-linked assets like stocks or mutual funds, it is not enough to simply compare the returns of different investments before making a choice. You need to also evaluate the risk-adjusted returns. Financial metrics like the Sharpe ratio and the Sortino ratio can help you with this.
In this article, we examine the meaning of these ratios and explore the Sortino ratio vs Sharpe ratio comparison.
What is the Sharpe ratio
The Sharpe ratio is a metric that evaluates the risk-adjusted returns of stocks and mutual fund schemes. Originally known as the reward-to-variability ratio, it was first developed by William F. Sharpe as a progression of his propositions about the Capital Asset Pricing Model (CAPM).
This ratio essentially tells you how much excess returns you earn from an asset for every unit of risk and volatility that you take on. It is particularly useful for evaluating highly volatile assets because it helps you see if the additional risk is set off by potentially higher risk-adjusted returns.
Sharpe ratio calculation
To calculate the Sharpe ratio, you need to compare the excess returns from an asset or portfolio with its standard deviation. The formula for this ratio is:
Sharpe ratio = (Rp — Rf) ÷ σp
Where:
Rp is the expected returns from the portfolio or fund
Rf is the risk-free rate
σp is the standard deviation of the portfolio or fund
What is the Sortino ratio
The Sortino ratio, like the Sharpe ratio, also helps you measure the risk-adjusted returns of a mutual fund, stock or portfolio. However, it only focuses on the downside risk or the standard deviation of the losses from a portfolio. In other words, it tells you the excess returns you can earn from a mutual fund or portfolio for every unit of downside risk you assume by investing in it.
The main difference between the Sortino ratio and the Sharpe ratio is the kind of volatility considered. While the Sharpe ratio assesses the risk-adjusted returns for the total volatility of an asset, the Sortino ratio tells you the excess returns you earn for the harmful volatility you endure.
This distinction is important because not all volatility is adverse. If the price of an asset or mutual fund moves in a favourable direction, it improves the risk-adjusted returns instead of eroding your gains.
Sortino ratio calculation
The formula to calculate the Sortino ratio is similar to the Sharpe ratio formula. The only difference between the Sortino ratio and the Sharpe ratio formulas is the type of standard deviation used. Check out the formula for the Sortino ratio.
Sortino ratio = (Rp — Rf) ÷ σp
Where:
Rp is the expected returns from the portfolio or fund
Rf is the risk-free rate
σp is the standard deviation of the negative or downside returns from the asset or portfolio
Also read: What is statutory liquidity ratio
Note: Analysts often use the Sharpe ratio to assess low-volatility investment portfolios, while the Sortino ratio is typically preferred for evaluating portfolios with higher volatility.
Differences between Sortino vs. Sharpe ratio
Now that you have seen the fundamentals of the Sortino ratio vs Sharpe ratio comparison, let us examine these details further. The table below summarises the differences between the Sortino ratio and the Sharpe ratio.
Particulars |
Sharpe ratio |
Sortino ratio |
What it measures |
The excess returns received for the extra volatility in a riskier asset |
The excess returns received for the extra negative volatility in an asset |
The type of volatility considered |
Considers the total volatility of an asset, thereby including both gains and losses |
Considers only the downside volatility, thereby focusing specifically on losses or negative returns |
Sensitivity |
Reacts to both positive and negative changes in the price or asset value |
Reacts only to negative changes in the asset value and ignores any positive performance |
Use cases |
Useful for general risk-adjusted performance assessment of investments |
Useful for evaluating investments where protection against downside risk is a priority |
How are the Sharpe ratio and the Sortino ratio used in investing
The Sharpe ratio and the Sortino ratio can be useful in different ways. Before you make a lump sum or SIP investment in a mutual fund or take a long position in any other asset, you can use the Sharpe ratio to evaluate the risk-adjusted performance of the asset. It also helps you compare mutual funds and optimise the risk-reward proposition in your existing portfolio.
The Sortino ratio is crucial for assessing the downside risk in any investment. It can also help you assess investment strategies and plays a pivotal role in performance benchmarking.
How to interpret Sortino and Sharpe Ratios?
Understanding the Sharpe and Sortino ratios helps investors evaluate whether their investment returns justify the risks taken. Both ratios measure risk-adjusted returns, and a higher value typically reflects better performance relative to the risk involved.
High Sharpe Ratio: Reflects strong risk-adjusted performance based on overall volatility. A ratio above 1 is good, above 2 is very good, and above 3 is excellent. It suggests the investment effectively balances risk and reward.
Low Sharpe Ratio: Implies that returns are not high enough to compensate for the level of risk taken—generally, a ratio below 1 is a red flag for poor efficiency.
High Sortino Ratio: Indicates strong returns with minimal downside risk. A ratio above 2 is favourable and shows the investment controls negative volatility while still delivering returns.
Low Sortino Ratio: Points to either underperformance or high downside risk. A ratio below 1 indicates the investment struggles with losses, making it less suitable for conservative investors.
What are the advantages of the Sharpe Ratio?
The Sharpe ratio offers several key benefits for evaluating investments:
- It is simple to compute and widely used in the investment industry.
- Serves as a dependable measure of risk-adjusted returns.
- Helps investors compare the performance of different investment options.
- Useful in assessing the effectiveness of various fund managers or portfolio strategies.
What are the limitations of the Sharpe Ratio?
Despite its usefulness, the Sharpe ratio comes with some limitations:
- It doesn’t reflect individual investor goals or objectives.
- Ignores an investor’s specific risk tolerance levels.
- Does not factor in the investment’s time horizon.
- Overlooks the liquidity or ease of accessing the invested capital.
What are the advantages of the Sortino ratio?
The Sortino ratio offers several meaningful benefits for evaluating investments:
- It aligns more closely with an investor’s specific goals or financial intentions.
- It considers the investor’s risk tolerance by focusing only on downside risk.
- It factors in the time horizon of the investment, which is essential for long-term planning.
- It helps assess the performance of different investment options more accurately.
- It also aids in comparing the effectiveness of various investment managers or strategies.
What are the disadvantages of the Sortino ratio?
Despite its strengths, the Sortino ratio comes with certain limitations:
- It is more complex to calculate than the Sharpe ratio.
- It is not as widely adopted or recognised as the Sharpe ratio.
- It does not take into account the liquidity of the investment.
- It does not consider the tax implications of the investment returns.
Conclusion
This sums up the Sortino ratio vs the Sharpe ratio comparison. The bottom line is that the Sharpe ratio and the Sortino ratio are both useful if you want to assess and compare mutual funds to make a smart investment decision. To choose from a variety of mutual funds in different categories with varying risk-adjusted returns, check out the 1,000+ mutual fund schemes on the Bajaj Finserv Platform.
