Key takeaways
- The Sortino ratio is a refinement of the Sharpe ratio: it measures return only in relation to downside risk.
- Upward swings are not penalised - only moves below the zero line count as risk.
- Higher is better. For the same portfolio, the Sortino ratio is usually higher than the Sharpe ratio.
What is the Sortino ratio?
The Sharpe ratio has a flaw: it treats upward and downward fluctuations alike. Yet hardly any investor minds a strong jump in gains - risk, as most people feel it, is above all what goes down. The Sortino ratio picks up on this: it divides the excess return not by the total volatility, but only by the downside deviation, which takes only the negative returns into account.
As a result, a portfolio is not penalised for occasionally rising sharply. What gets rewarded is achieving good returns with loss phases kept as small as possible.
Sortino or Sharpe?
The two metrics complement each other:
| Metric | Risk measure in the denominator | Penalises upward swings? |
|---|---|---|
| Sharpe ratio | total volatility | yes |
| Sortino ratio | downside deviation only | no |
If the Sortino ratio is well above the Sharpe ratio, it means that a large part of your fluctuation went upwards - the pleasant kind of fluctuation.
How Talantor calculates it
Talantor looks at the daily returns of your time-weighted history, collects only the negative deviations (below a target return of 0) and derives the annualised downside deviation from them. The annualised excess return - again with a risk-free rate of 0 - is divided by this value.
Good to know
Because only loss days feed into the denominator, the Sortino ratio needs enough of them to be stable. In very calm or very short periods it can swing considerably or be missing.