Sortino

The Sortino ratio is a risk-adjusted performance metric used in finance to evaluate an investment's returns relative to downside risk. It is named after Frank A. Sortino, who popularized its use in the 1980s and 1990s as an alternative to the Sharpe ratio for assessing performance.

Definition and calculation: The ratio is defined as (R_p - R_t) / σ_d, where R_p is the portfolio return over a chosen period, R_t is the minimum acceptable return (target), and σ_d is the downside deviation. Downside deviation is the square root of the average of squared negative deviations of returns below R_t. In practice, only returns that fall short of the target contribute to the denominator, making the metric focused on downside risk.

Comparison and use: Sortino is similar to the Sharpe ratio but replaces total volatility with downside risk, which can make it more sensitive to harmful outcomes while ignoring upside volatility. It is widely used to evaluate and compare investment funds and portfolios, particularly for investors who are concerned with drawdowns and downside protection.

Limitations and considerations: The choice of target return R_t significantly affects the ratio, and there can be instability with small samples or short time windows. Like other historical performance measures, the Sortino ratio relies on past data and may not fully capture future risk dynamics. It should be used alongside other metrics to form a comprehensive assessment of risk and return.