The Sortino ratio
measures the risk-adjusted return
of an investment asset, portfolio or strategy. It is a modification of the Sharpe ratio
but penalizes only those returns falling below a user-specified target, or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility
equally. It is thus a measure of risk-adjusted returns that treats risk more realistically than the Sharpe ratio.The ratio is calculated as:
- <math>S = frac</math>,
where R is the asset or portfolio realized return; T is the target or required rate of return for the investment strategy under consideration, (T was originally known as the minimum acceptable return, or MAR); DR is the downside risk. The downside risk is the target semideviation = square root of the target semivariance (TSV). TSV is the return distribution's lower-partial moment
of degree 2 (LPM<sub>2</sub>).
- <math>DR = left( int_^T (T - x)^2,f(x),dx right)^, </math>
where <math>T</math> is often taken to be the risk free interest rate and <math>f()</math> is the pdf
of the returns. This can be thought of as the root mean squared
underperformance, where the underperformance is the amount by which a return is below target (and returns above target are treated as underperformance of 0).
Thus, the ratio is the actual rate of return in excess of the investor's target rate of return, per unit of downside risk; or, overperformance divided by... Read More