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!

*   *   *   *   *   *   *   *

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.

The performance data displayed herein is compiled from various sources, including BarclayHedge, RCM's own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark 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, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.