Monday, April 04, 2011

Sortino Ratio

Last week we had a hedge fund manager in SIMM and he spoke of the Sortino Ratio. It was a new topic for most in the class so we will be going over it again in today's class so so I might as well share it.

Most investors are more concerned with losses than gains. Thus a measure such based on variance or standard deviation may unintentionally penalize a fund that is measured using symmetric measures.
The Sortino Ratio aims to reduce this problem by using a set Target (for instance zero) and only counts the observation if it is below the target.

From The Curious Investor:

"The Sharpe ratio is a slightly more exacting portfolio risk calculation in comparison to the beta and alpha combination, but, for all intents and purposes, delivers similar information in that it attempts to quantify how much a portfolio strategy made in excess of the volatility (risk) it assumes. The Sortino Ratio is an adjustment on the Sharpe Ratio in that it only penalizes downside volatility. This is done by creating a value known as downside deviation which is based on some minimum acceptable return (MAR) which is a rate of return that an investor can set. This could be 0%, if you want to judge your portfolio on how well it operates with respect to never losing money."

The SharpInvesting Blog has some examples of historical ratios as well as more on how to calculate:

"The Sortino Ratio differentiates between this positive and negative volatility by replacing standard deviation with downside-volatility. Downside-volatility is the volatility of returns below a minimal acceptable return (MAR). The MAR is usually set at 0%. Distribution of returns is analysed below this MAR. The denominator of the Sortino ratio is calculated only with data from periods where performance was below the set MAR. This differentiates the “positive” and “negative” volatility."

Don't want to do it yourself? Here is a calculator for it (I should note I did not check its accuracy) as well as directions on how to set up in Excel from CuriousInvestor.

I would add that dropping the positive numbers (instead of setting them equal to zero or the Target) seems to make more sense.

1 comment:

Sim Con said...

I've also got an Excel spreadsheet to calculate the Sortino Ratio. Feel free to download it. There are several methods to calculate the downside deviation. I've chosen to use the 2nd order lower partial moment.