Sortino Ratio

The Sharpe ratio treats all volatility as bad, including large gains. Most investors do not mind upside surprises; what hurts is losses. The Sortino ratio, named after Frank Sortino, addresses this by dividing excess return by downside deviation, a measure of volatility that counts only returns below a target. Strategies with frequent big gains and limited losses score better on Sortino than on Sharpe, while strategies with hidden crash risk do not get rewarded for smooth upside.

The formula#

Sortino ratio = (Portfolio return - Target return) / Downside deviation

• Target return: often zero or the risk free rate; also called the minimum acceptable return (MAR).
• Downside deviation: the square root of the average of squared shortfalls below the target, where returns above the target count as zero shortfall.

Calculating downside deviation#

1. Subtract the target from each period's return.
2. Replace positive results with zero.
3. Square the remaining negative values.
4. Average across all periods (including the zeros).
5. Take the square root, then annualise.

Sharpe versus Sortino#

Trend following and long option strategies often have positive skew and look better on Sortino. Option selling has negative skew; both ratios can look excellent until a crash appears in the record. See Skewness and Kurtosis and Trend Following.

Interpreting values#

There is no universal scale, but because downside deviation is usually smaller than total volatility, Sortino ratios are typically higher than Sharpe ratios for the same strategy. Compare Sortino ratios only with other Sortino ratios, using the same target and frequency.

Limitations#

• Few negative periods make downside deviation unreliable; a short record with only a few losses can produce huge ratios.
• Target choice changes the result; always state it.
• Calculation variations: some sources average squared shortfalls only over negative periods, which inflates downside deviation. State your method.
• Does not capture drawdown depth or duration. See Maximum Drawdown and Calmar and MAR Ratio.

When to use it#

• Comparing strategies with asymmetric returns, such as trend following versus mean reversion.
• Evaluating strategies where investors care about losses below a specific threshold.
• Alongside Sharpe, not instead of it; a large gap between the two tells you about the shape of the return distribution.

Frequently asked questions#

What is the Sortino ratio?#

A risk adjusted return measure that divides excess return over a target by downside deviation, penalising only returns below the target.

Is the Sortino ratio better than the Sharpe ratio?#

It is more informative for strategies with asymmetric returns, but it is less reliable with few losing periods. Using both together is best.

What is a good Sortino ratio?#

It depends on the target and data frequency; it is usually higher than the Sharpe ratio for the same strategy, and should be compared like for like.

Next, learn ratios based on drawdowns in Calmar and MAR Ratio.