Whiteboard Video Series: What are Sharpe and Sortino Ratios?
Watch this short 5-minute educational video to learn more about sharpe and sortino ratios and what they mean for your client portfolios.
As part of our ongoing University of Alts content library, today we're going to cover Sharpe ratio and Sortino ratio.
As always, we'll start with a definition. Sharpe ratio is the excess return of a portfolio above the risk-free rate relative to its standard deviation. Sortino ratio is the excess return of a portfolio above the risk-free rate relative to its downside deviation. As you can see, these are both meant to help gain a better understanding of a given investment's risk-adjusted returns. However, because Sharpe ratio does not distinguish between upside – or good volatility – and downside – or bad volatility – Sortino is often a preferred measure of risk-adjusted performance.
Next, let's talk about why this is an important metric to take into consideration, especially when comparing funds in the alternative space. Oftentimes, managers will tout their investment performance but not give a clear indication of the amount of risk they employed to achieve these longer-term numbers.
Sharpe and Sortino ratio can help to identify whether your manager is delivering enough return to make up for the amount of risk you are taking as an investor. If the Sharpe or Sortino ratio is greater than 1, you have effectively been compensated for this risk, with higher numbers meaning greater risk-adjusted returns. Any number less than 1 would indicate that your manager has delivered returns that do not make up for the amount of risk they have taken.
Now, let's look at how you calculate these ratios. As you can see, they are nearly identical, except for the fact that to calculate Sharpe ratio we divide our portfolio return minus the risk-free rate by standard deviation, or overall volatility, while for Sortino ratio we divide the portfolio return minus the risk-free rate only by our downside deviation, or downside volatility.
Next, we'll go through a couple of examples to see how these ratios can provide additional insight into a fund's risk and return profile. First, let's start with Sharpe ratio. In this example, Fund A returned 10% with a standard deviation of 12%, while Fund B returned 8% with a standard deviation of 6%. We'll also assume a risk-free rate of zero, for ease of calculation.
Let's plug these numbers into our formula for Sharpe ratio. As you can see, despite its higher absolute return Fund A's Sharpe ratio is just 0.83, or under the target of 1, while despite having a lower absolute return Fund B has a Sharpe ratio of 1.33 and, thus, has provided greater risk-adjusted returns.
Next, let's look at Sortino ratio. Let's say Portfolio A returned 10% with a standard deviation of 10% and downside deviation of 8%, while Portfolio B returned 10% also with a standard deviation of 10% but a downside deviation of just 6%. Again we'll use a risk-free rate of zero for ease of calculation. We already know that each of these funds with identical returns and identical standard deviations will have the same Sharpe ratio. But once we take that a step further and look at Sortino ratio, we can see that Fund B has a higher value, given that it takes on less downside risk.
While managers often like to highlight their absolute returns, whether over other funds in the category or the market as a whole, as an investor it is incredibly important to also take into consideration the amount of risk that was undertaken to achieve these returns and to make sure that you are compensated appropriately for taking on this risk. Sharpe and Sortino ratio are two statistics that allow us to effectively do just that.