Using the Sortino Ratio to Gauge Downside Risk

You're investing part of your savings over the next three years for a downpayment on a home or possibly your child's first year of college. The right investments can help you meet your goals faster—but you realize you can't take the risk of significant market losses setting you back.

How can you tell if an investment you're looking at has a track record of avoiding downside volatility, better known as potential losses?

The Sortino ratio, named for economist Frank Sortino and his investment work in the early 1980s, may help guide you in the right direction. This particular formula only uses annual downside volatility of the investment in its calculation, giving you a potentially clearer picture of an investment or a portfolio's risk-adjusted return.

If you have a relatively short investment time horizon (say three years), downside risk is all the more important to your investment decisions. The Sortino ratio can help you measure this exposure, so you know how much risk you're potentially taking on. Remember, though, as with most market calculations, the Sortino ratio uses historical data to produce a result. Past performance is no guarantee of future results.

The Sortino ratio is one of three key metrics of risk-adjusted performance used by professional portfolio managers; the other two metrics are the Sharpe ratio and the Information ratio.

The Sortino ratio is a variation on the Sharpe ratio. While the Sharpe ratio measures excess returns against total volatility (gains and losses), the Sortino ratio is built to focus on weighing the potential for downside risk.

According to Viraj Desai, director of Schwab Asset Management, "You'll see the Sortino ratio most frequently used by investors who have a very low risk tolerance and a generally short investment time horizon—less than three years, for example. Those with longer-term investment time horizons may bypass the Sortino ratio and focus on the Sharpe or Information ratios for a broader idea of upside and downside risk. But in short-term investment situations where goals are near, investors would do well to pay closer attention to the Sortino ratio."

The Sortino ratio begins with an investor's desired return they want to beat based on their risk tolerance and investment time horizon.

For example, investors may choose from a range of variables to plug in to the equation, including major stock indexes like the S&P 500^® (SPX), a specific U.S. Treasury rate (the lower risk rate), or in the case of some professional portfolio managers, a client-specified return referred to as the minimal acceptable return (MAR) they need to meet or beat.

For uniformity's sake, we'll make the lower risk rate in the equation the 10-year Treasury note (TNX) yielding about 4.20% as of early March 2024. 

Here's how that equation would look.

Sortino ratio = (Rp – Rf) ÷ Downside deviation

Key:

• Rp: Investment return (actual or forecast)—this is the investment's current annual return, and you'll find it in the fund's fact sheet or prospectus.
• Rf: Risk-free rate—the low-risk rate of return you hope to beat, usually a U.S. Treasury yield. (Though Desai pointed out that investors can elect to use their own measure for that return, such as a MAR.)
• Downside deviation: This is a measure of the investment's downside volatility or losses. A lower standard deviation implies less risk and consequently a higher Sortino ratio. A higher standard deviation implies more risk and a lower Sortino ratio. You'll typically find this data in the investment's fact sheet or prospectus. 

The Sortino ratio gives investors an idea of how much risk they could face over time based on historical data. The higher the Sortino ratio, the better the return for the amount of risk taken on: 

• Less than 0 is considered not acceptable for inclusion in one's investments.
• 0.00 – 1.00 is considered suboptimal. 
• Above 1.00 is considered good.
• Above 2.00 is considered very good.
• Above 3.00 is considered excellent.

As with most any portfolio calculation, the Sortino ratio has limitations investors should be aware of:

• The Sortino ratio is calculated using historical performance data, which may not hold up in the future. Investors would do well to view the Sortino ratio as a snapshot of that investment's potential loss risk based on the latest market data available. 
• The Sortino ratio is not recommended for highly volatile investments, sometimes known as alternative investments, including commodities, publicly traded hedge funds, real estate, or some long/short strategies. That's because this ratio does not capture what could be significant upside volatility or gains.
• Even though the Sortino ratio is seen as a useful barometer for risk-averse investors with short time horizons, most experts note that using less than three years of historic data can weaken the validity of its calculation. "Ten years' worth of data is ideal for the Sortino ratio because it will encompass an entire business cycle," Desai explained.

Combined with the other two risk-adjusted metrics (Sharpe ratio and Information ratio), the Sortino ratio focuses on the downside risk profile of an asset over time. The Sortino ratio can be especially useful for investors with a low risk tolerance or a short-term investing time horizon, so they will want to pay closer attention to the fund's Sortino ratio than a long-term investor might.