Two performance ratios that often pop-up on the fact sheets of unit trusts are the Sharpe Ratio and the Sortino Ratio. Many do not however know that the Sortino Ratio was developed to overcome some of the short-comings of the Sharpe Ratio.
Firstly the Sharpe Ratio measures how well a fund has performed given its level of volatility. Without getting too complicated, imagine two funds have the same return figures however the volatility of one of the funds is lower than the other. Thus the fund with the lower volatility would have the higher Sharpe Ratio.
To understand why the Sortino Ratio was developed, firstly you would need to understand how standard deviation works. In finance standard deviation is used as a measure of risk/volatility. Again without getting too technical, standard deviation measures the dispersion of a set of data from its mean, in this case the observed returns of an investment.
The graph above shows returns data for hypothetical Fund X over a given period. The standard deviation will then be measured by how much each of the observed returns is dispersed from its mean as shown by the solid blue line. Thus the higher (lower) the standard deviation the higher (lower) the volatility.
This is where the Sharpe Ratios weakness starts to show and why the Sortino Ratio was developed. The Sharpe Ratio penalizes for total volatility. That is to say that each data point above and below the mean is taken into account when determining risk. Surely fund managers should be praised for generating returns above the mean and not penalized.
The Sortino Ratio fixes this problem. It is computed the exact same way as the Sharpe Ratio however it only takes into account the downside deviation (data points below the mean) and does not penalize upside deviation (data points above the mean). A high Sortino Ratio indicates a low probability of large losses, and vice versa for a low Sortino Ratio.
To conclude both ratios are popular tools to measure performance, however like many other statistical measurements used in finance, they do not paint a 100% accurate picture and holes can always be found in each. This is not to say that there is no merit in their use and application, but rather when making investment decisions, the qualitative aspects of the funds you’re looking to invest in can be just as important as the quantitative aspects.