Understanding Sharpe and
Sortino Ratio
by Abrar July 24, 2021
Risk Measurement
Contrary to popular belief, an investor's selection of mutual funds solely relies on returns, this is not true. A portfolio's performance must also be measured against volatility, a contributing factor in risk-adjusted returns. Sharpe and Sortino's ratios both evaluate the performance of Return on Investment (ROI). This article briefly introduces the two ratios and presents their limitations, differences, similarities, and outcome significance.
Sharpe Ratio
The Sharpe Ratio is the popular metric for assessing the viability of a strategy or portfolio. It measures the outperforming return per unit of deviation in a trading strategy or an asset to calculate how desirable a risky investment or strategy performs against a risk-free investment, such as government-issued bonds, by considering the added risk level involved when holding the asset.
Application
Sharpe ratio compares the impact to a portfolio's overall risk returns to a new asset and derives if the returns are accomplished due to high risk or decision making.
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Formula to calculate Sharpe ratio:
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Sharpe ratio = (Mean portfolio return – Risk- free rate of return)/Standard deviation of portfolio return
Limitations
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It does not differentiate between upside and downside volatility; from an investor's perspective, a substantial upside is a positive characteristic but is shadowed by the Sharpe Ratio.
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Application is limited for the portfolios with a normal distribution of expected returns.
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Fails to analyze non-linear risks such as a portfolio with warrants and options.
Sortino ratio
The Sortino Ratio is similar to Sharpe Ratio in some aspects, except the Sortino ratio provides better insight into the risk corresponding to related strategy or asset. In contrast to the Sharpe ratio, Sortino Ratio measures volatility considering the standard deviation of the negative returns; this translates to a high Sortino ratio predicting the low probability of significant losses.
Application
The Sharpe Ratio evaluates profit, volatility, and risk-free investment profit (such as treasury bills).
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Formula to calculate Sortino ratio:
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Sortino ratio = (Expected return – Risk- free rate of return)/Standard deviation of negative asset returns
Limitations
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Sortino ratio is not effective in measuring risk over extensive timelines as volatility of returns is low due to insufficient data.
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Demands sufficient bad risks or observations to calculate accurately since the Sortino ratio considers downside deviation for risk measurement.
Sharpe vs Sortino
The Sharpe ratio provides the equity investment performance compared to a risk-free investment, considering the increased risk with the equity investment holding. In the case of the Sortino ratio, only downside risk factors are taken into account.
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Upside volatility is omitted in the Sortino ratio's calculation as it uses only downside deviation. However, the Sharpe ratio's Standard deviation calculates data dispersion both above and below its mean. As a result, the Sortino ratio does not guarantee future returns.
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The popularity of the Sharpe ratio allows the convenience of comparing investment strategies across asset classes, whereas the Sortino ratio faces limited data searching for negative deviations.
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Sharpe rewards only investment strategies that overcome the risk-free rate of return and penalizes those not consistent in returns; this is a significant drawback as traders and investors might not choose the risk-free rate of return as the target.
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Sharpe ratio thrives on evaluating investment portfolios with low volatility and normal distribution. In comparison, the Sortino ratio works better if the strategy consists of high volatility.
Significance of Sharpe and Sortino Ratio Outcomes
A negative Sharpe ratio indicates that the investment secures a better risk-adjusted rate of profit with the assistance of a risk-free investment option.
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A Sortino ratio which is one or higher is concluded to be a risk-adjusted return of earnings.
Conclusion
Sortino ratio is one way to go about calculating risk-adjusted returns. Optimum for the investors comparing portfolios based on the downside volatility. In reality, upside volatility cannot be ignored completely. Upside volatility returns are achieved by acquiring additional risks. Risk leads to both upside outperformance and downside underperformance.
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Neither Sortino nor Sharpe can go wrong in their entirety. Both of them deliver results allowing the investors to compare trading and investment strategies. Neither of these metrics does a perfect job at evaluating the quality of a strategy that does not follow a normal distribution of returns.
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There is no room for perfection in the world of finance management, but only for getting closer to it.
References
India Infoline News Service. (2020, 08 10). Sortino Ratio: Is it better than Sharpe in judging MF performance? Retrieved from Indiainfoline.
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Manish. (n.d.). Sharpe Ratio: One can use it to pick best mutual funds. Retrieved from Getmoneyrich.
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Maverick, J. (2021, 05 31). The Difference Between the Sharpe Ratio and the Sortino Ratio. Retrieved from Investopedia.
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Siligardos, D. G. (2020, 05 13). Sharpe vs. Sortino: choosing the right reward/risk metric for your strategies. Retrieved from Intalcon.
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StockEdge. (2020, 10 21). How to use Sortino Ratio to select good mutual funds for investing? Retrieved from Stockedge.