The Sortino Solution to the Sharpe Ratio

This post is part of an ongoing series on the Attain Capital blog that seeks to help investors understand the various metrics we use to evaluate managers. Stay tuned for future pieces!

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We recently did a post that explained everything you’d want to know about the Sharpe Ratio: how it’s calculated, why it matters, and how you should use it. The short version is that the Sharpe Ratio is a stat which measures returns relative to volatility. In looking back at that piece, however, we failed to mention one of the big failings of the Sharpe ratio (we mentioned three others).

That failing is that the Sharpe ratio considers all volatility in an investments’ returns a bad thing. But is a large upside return really a bad thing? Some may say yes, as it means they could have an equally as large negative return. But for investments with a long volatility profile where they can earn outlier returns by letting profits run, punishing programs for those outlier returns (because they increase the investment’s overall volatility) doesn’t seem to make a lot of sense.

So how do you solve for this deficiency? Enter the Sortino Ratio, which is essentially the same thing as the Sharpe ratio – measuring returns over volatility- but which only considers downside volatility.

What is it? The Sortino Ratio is a risk adjusted return statistic which measures an investment’s return per unit of risk, with risk equal to the standard deviation of negative returns.

Sortino = (Compound ROR – risk free ROR) / (Standard Deviation of Negative Returns)

The Sortino Ratio, developed by Director of the Pension Research Institute Dr. Frank A. Sortino in 1980, can be viewed a modification of the Sharpe Ratio that treats risk only as the downside volatility  in an effort to solve for the Sharpe’s problem of penalizing programs for positive outliers, as the Sharpe Ratio penalizes both upside and downside volatility equally. This solves the bulk of our issue with the Sharpe Ratio’s limitations, but is not without its own problems.

Remaining are two of the problems we mentioned in discussing the Sharpe ratio – 1. That there is a lot more to risk than just volatility (even downside volatility), and 2. Using volatility assumes returns are distributed normally – which they aren’t. From the Sharpe post:

The largest issue of using volatility of returns, and more technically the standard deviation of returns, is that using such a calculation assumes a normal distribution of returns. That means the Sharpe ratio assumes returns are spread nice and evenly on a bell curve, like the heights of students in a grade school. Thing is, the financial world is anything but a nice smooth bell curve, with events which are deemed to happen once every 10,000 years on the bell curve happen once a year or more. Financial returns are not normally distributed, so using such a metric to gauge their performance is fraught with problems.

On final point – while the risk metrics you’ll see on the Attain website and others offer valuable insight to the investor, looking at a statistic in a vacuum is fairly worthless. For one, the Sortino Ratio, much like other ratios used, is only meaningful when compared to the Sortino ratio of another program. The higher the number, the better, but on its own, a 1.42 Sortino Ratio means nothing. Moreover, even when used to compare programs, as we’ve explained, the Sortino Ratio does not provide the full picture, so it is best used in conjunction with a variety of other metrics.


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DISCLAIMER

Forex trading, commodity trading, managed futures, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.

The entries on this blog are intended to further subscribers understanding, education, and – at times- enjoyment of the world of alternative investments through managed futures, trading systems, and managed forex, and is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument. Unless distinctly noted otherwise, the data and graphs included herein are intended to be mere examples and exhibits of the topic discussed, are for educational and illustrative purposes only, and do not represent trading in actual accounts. Opinions expressed are that of the author.

*The mention of specific asset class performance (i.e. +3.2%, -4.6%) is based on the noted source index (i.e. Newedge CTA Index, S&P 500 Index, etc.), and investors should take care to understand that any index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship and self reporting biases, and instant history.

The mention of general asset class performance (i.e. managed futures did well, stocks were down, bonds were up) is based on Attain’s direct experience in those asset classes, estimates of performance of dozens of CTAs followed by Attain, and averaging of various indices designed to track said asset classes.

It should be noted that past market performance is not indicative of future market movement.No market data or other information is warranted by Attain Capital Management as to completeness or accuracy, express or implied, and is subject to change without notice.

Managed Futures Disclaimer:

Past Performance is Not Necessarily Indicative of Future Results. The regulations of the CFTC require that prospective clients of a managed futures program (CTA) receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the client’s commodity interest trading and that certain risk factors be highlighted. The disclosure document contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA.