What is Sortino ratio and how is it used?

The Sortino ratio can help traders and analysts consider whether an investment’s return has been achieved with a proportionate level of downside risk.

Key takeaways

Sortino ratio is:

a measure of an investment's return compared with its downside volatility
focused mainly on price movements that fall below a target return, rather than all price changes
often higher when an investment generates returns with lower downside deviation, although it should be read alongside other measures

What is the Sortino ratio?

When reviewing an investment fund, you may first look at its total return. A portfolio that grew by 30% over a year may look effective at first glance. However, returns alone do not show how much downside risk the portfolio took to reach that result. To look at this more closely, portfolio managers may use the Sortino ratio, developed by economist Dr Frank Sortino at the Pension Research Institute in the early 1980s (Cambridge University Press, 2009).

Put simply, the Sortino ratio is a risk-assessment tool that helps measure an investment's return in relation to its downside volatility. It can help answer a practical question: did a fund generate returns with relatively limited downside risk, or did it rely on larger price swings that could have led to bigger losses?

In finance, the Sortino ratio may be used by pension funds, hedge fund analysts and wealth advisors. Traditional risk tools can penalise a fund if its price moves sharply higher, because they treat both upward and downward volatility as risk. The Sortino ratio takes a narrower view by focusing on negative returns that fall below a chosen target.

Sortino ratio definition

The formal definition of the Sortino ratio is a statistical modification of the traditional Sharpe ratio that isolates downside risk from total risk. It measures the excess return of an investment portfolio over a specified minimum acceptable return (MAR), divided by the portfolio's downside deviation. This provides a view of the asset's performance per unit of downside volatility.

Meaning of Sortino ratio explained

To understand what the Sortino ratio is, imagine comparing two commodity CFD traders who specialise in crude oil futures. Trader A buys oil contracts ahead of a major geopolitical event. On days when oil prices rise sharply, their portfolio gains 20%, but when prices pull back, it suffers sudden 15% drops. Trader B uses options strategies to trade the same oil market. When oil prices rise sharply, Trader B's portfolio also captures a 20% gain, but because they hedged their position, their portfolio moves less sharply when oil prices pull back, limiting their worst daily loss to 1%.

Traditional risk metrics may treat both traders as equally risky because both portfolios experience large, rapid price movements. The Sortino ratio gives a different view by largely excluding Trader A's upward moves and focusing more on the 15% drops.

In financial markets, upward movement may contribute to investment return, while downward movement can create downside risk.

The Sortino ratio is a performance metric that compares an investment portfolio's return with the downward price movements that may affect an investor's capital.

How does the Sortino ratio work?

To calculate the ratio, returns are separated into those above and below a target rate.

Sortino ratio = (Rp – T)/DR

Here:

Rp is the return generated by the investment over a specific time period.
T is the minimum acceptable return the investor requires. Analysts often use the yield of a low-risk government Treasury bond for this.
DR is the downside deviation.

Instead of measuring all price fluctuations, the Sortino ratio calculates the standard deviation of only the returns that fall below the target rate (T). This means positive, upward moves are excluded from the downside risk calculation.

Why is Sortino ratio important?

The Sortino ratio can help analysts assess downside risk and compare how efficiently different strategies generate returns. It may be useful when comparing funds with similar returns but different patterns of losses.

It can also help analysts review higher-growth or more volatile strategies, such as tech sector funds or crypto portfolios, where large upward swings could distort traditional risk calculations.

For businesses, pension funds and other investors, the Sortino ratio may support wider risk analysis when comparing instruments that have different levels of exposure to severe or unexpected drawdowns. However, it should not be used on its own. Like any single metric, it has limitations and works best when considered alongside other measures, market context and the investor’s objectives.

How the Sortino ratio applies to CFD trading

The Sortino ratio can be relevant to CFD trading because it focuses on downside risk, rather than all price movement. Since contracts for difference (CFDs) are traded on margin, losses can be amplified if the market moves against your position.

A trader might use the Sortino ratio to review how a CFD strategy has performed against its downside volatility over a specific period. For example, two strategies may generate similar returns, but the one with smaller drawdowns could have a higher Sortino ratio.

However, the Sortino ratio is only one measure. It should be considered alongside other factors, such as market volatility, trading costs, leverage, stop-loss use, liquidity and overall risk exposure.

Contracts for difference (CFDs) are traded on margin. Leverage can amplify both profits and losses. Standard stop-loss orders aren’t guaranteed.

Sortino ratio example

Let's see how the Sortino ratio is used by comparing two hypothetical investment portfolios, Fund X and Fund Y, which both earned a 12% total return last year. The target minimum return is set at 2%.

Fund X hit its 12% return by trading volatile meme stocks. It had large upward days but also suffered 15% drops when the market turned. Its calculated downside deviation is 5%.
Fund Y hit its 12% return by holding a mix of dividend stocks and corporate bonds. Its price moved up more steadily, and its worst drop was 2%. Its downside deviation is 2%.

So:

Fund	Sortino ratio calculation	Result
Fund X	(12% – 2%)/5%	2.0
Fund Y	(12% – 2%)/2%	5.0

Even though both funds generated the same 12% return, Fund Y has a higher Sortino ratio of 5.0. In this example, that suggests Fund Y achieved its return with less downside risk than Fund X. This does not automatically make Fund Y the better choice, as investors would also need to consider factors such as liquidity, costs, asset class, time horizon and wider market conditions.

This content is provided for general information and educational purposes only. It does not constitute investment advice, financial advice, a recommendation, or an offer or solicitation to buy or sell any financial instrument.

Create an account Open a demo account

FAQ

What is a good Sortino ratio?

Among many investment professionals, a Sortino ratio of 2.0 or higher is often viewed as strong. It may indicate that a strategy has generated returns without exposing capital to large downside moves. However, what counts as a good Sortino ratio can vary by asset class, time period and market conditions.

Is a high Sortino ratio better?

A higher Sortino ratio is generally considered preferable because it suggests that a strategy has generated more return for each unit of downside volatility. However, a very high ratio may also reflect an unusually low downside deviation over the period measured, so it should be read alongside other risk measures.

What is the difference between Sharpe ratio and Sortino ratio?

Sharpe ratio uses total standard deviation as its risk metric. It treats both downward moves and upward moves as risk, which can make some high-growth or volatile strategies look less efficient. The Sortino ratio uses downside deviation instead, focusing on returns that fall below the investor's minimum target. This gives a more specific view of downside risk, but it does not replace broader analysis.