The Sortino Ratio is an important metric to consider when evaluating hedge funds and other alternative assets. Essentially an improved Sharpe Ratio, Sortino measures performance per unit risk, but only considers downside risk. Recall, when discussing investment returns, risk is actually volatility of returns- in other words, returns both above and below the mean contribute to increasing risk. The sortino ratio takes into account only volatility below the mean when calculating return per unit of risk, as investors generally are not concerned if returns are greater than average.
Q. OK, we know this is another one of the performance metric from alt land. What does this one show us?
A. Well, it’s essentially the Sharpe Ratio, but with an important twist. But so we can explain it properly, let’s back up a bit. We know that the big idea of MPT—modern portfolio theory – is to measure return per unit of risk, eh? Not just how much I made, but what risk did I take to do it?
Q. Right, and that’s the Sharpe ratio, the big statistic for measuring return for unit of risk. And larger is better.
A. Yes. OK, now recall that in MPT, “risk” and “volatility” are the same thing; if a portfolio has had a lot of volatility, it’s got a lower Sharpe ratio. That’s because to get the Sharpe, you divide performance by deviation (again, equal to volatility and risk). Therefore, the higher the deviation, the lower the Sharpe; the lower the deviation, the higher the Sharpe.
Q. OK. So, what’s the twist that Sortino introduces? Is it important?
A. Yes! I thought of doing this as a buzzword yesterday when I was evaluating a manager who had an mediocre Sharpe ratio but a stunning Sortino. To get the Sortino, we switch out the normal Sharpe denominator. Instead of using total deviation, we use downside deviation. We ignore upside volatility.
Q. Because, after all, who minds upside volatility?
A. Right, that was the story yesterday: the guy’s Sharpe was about 1.8, but his Sorrentino—which is measured on the same scale—was over 4. So, looks like he does take some risks, but generally does well with it.
Q. Sounds sort of like a baseball player with a normal batting average, but a lot of home runs?
A. Exactly! A high Sorrentino shows you limited risks of big downside movements, but a good chance of upside performance. This guy yesterday was a pretty disciplined hitter, but does take chances by swinging at a few pitches slightly outside the strike zone. The good news is that a lot of those wind up over the fence.
Q. I think I see a whole new way for Bloomberg to cover sports here…