In the series of articles on risk-adjusted returns, Sortino is another important ratio. Like Sharpe, Sortino uses standard deviation as the risk measure to adjust the returns. However, the difference is that Sortino uses only the downside standard deviation of a portfolio, ignoring the overall standard deviation.
Simply saying, positive volatility is anyway a benefit to the investor. So the Sortino ratio focuses mainly on a portfolio's negative volatility of returns from the portfolio's mean.
Suppose a fund has an overall standard deviation of 22% (a positive deviation of 10% and a negative deviation of 12%). Now Sharpe Ratio considers standard deviation as a whole at 22%, while Sortino Ratio considers only the negative deviation of 12%; as a result, a clearer view of the downside risk-adjusted returns can be achieved.
Similar to Sharpe Ratio, the Sortino Ratio should also be used as a comparative measure within the funds in the same segment.
The formula to calculate Sortino Ratio is (Rp-Rf)/Std. Dev(N)
Rp – Returns of the portfolio
Rf – Risk-free rate
Std. dev (N) – Negative Standard Deviation of the portfolio
Let's say a fund YYY has a 3-year negative standard deviation of 15%, 3-year returns at 17%, and the risk-free rate is 6%.
Let's say a fund ZZZ has a 3-year negative standard deviation of 12%, 3-year returns at 16%, and the risk-free rate is 6%.
Thus, the above comparison says that during the negative periods, the ZZZ's portfolio performs better than the portfolio of YYY.
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