What Are the Sharpe and Sortino Ratios
The Sharpe ratio measures how much excess return (above the risk-free rate) a portfolio generates per unit of total volatility, calculated as (portfolio return minus risk-free rate) divided by the standard deviation of returns. It’s one of the most widely used risk-adjusted return metrics in finance, allowing investors to compare strategies with different volatility profiles on a like-for-like basis.
The Sortino ratio uses a similar structure but replaces total standard deviation with ‘downside deviation’ — volatility measured only from returns that fall below a minimum acceptable threshold. In other words, it treats upside volatility (big gains) as harmless and only penalizes downside volatility (losses).
Why the Distinction Matters
The Sharpe ratio treats all volatility as risk, whether the swings are to the upside or the downside — meaning a strategy with occasional large gains can be penalized by a lower Sharpe ratio even though investors generally welcome that kind of volatility. The Sortino ratio corrects for this by only counting downside deviation, which can make strategies with asymmetric, upside-skewed return profiles look considerably more attractive under Sortino than under Sharpe.
Consider two strategies with identical average returns: Strategy A has symmetric volatility (equal-sized gains and losses), giving it Sharpe and Sortino ratios that are close to each other. Strategy B has occasional large gains but small, controlled losses — its Sortino ratio comes out meaningfully higher than its Sharpe ratio, since Sortino doesn’t penalize the large upside moves.
Choosing Between the Two
Since the Sharpe ratio treats upside and downside volatility equally, it’s a reasonable general-purpose metric when a strategy’s return distribution is roughly symmetric. But for strategies with asymmetric payoffs — such as options-based approaches or trend-following systems that aim for small, frequent losses and occasional large gains — the Sortino ratio often provides a more meaningful picture of true downside risk.
Many professional investors look at both metrics together rather than relying on just one, since comparing the two can itself reveal whether a strategy’s volatility is mostly coming from the upside or the downside.
| Metric | Sharpe Ratio | Sortino Ratio |
|---|---|---|
| Risk measure used | Total standard deviation | Downside deviation only |
| Treats upside volatility as risk? | Yes | No |
| Best suited for | Symmetric return distributions | Asymmetric, upside-skewed strategies |
Frequently Asked Questions
Is a higher ratio always better for both Sharpe and Sortino?
Generally yes, a higher ratio indicates more return per unit of risk taken, but it’s important to compare ratios calculated over similar time periods and against relevant benchmarks rather than looking at the number in isolation.
Can these ratios be negative?
Yes, if a portfolio’s return falls below the risk-free rate, the ratio becomes negative, which typically signals the strategy underperformed a risk-free investment on a risk-adjusted basis over that period.
Which ratio do hedge funds tend to prefer reporting?
Strategies with asymmetric return profiles, like many options or trend-following strategies, often highlight the Sortino ratio since it tends to present their risk-adjusted performance more favorably than the Sharpe ratio.
What’s a reasonable minimum acceptable return for calculating Sortino?
The risk-free rate is a common default choice, though some investors use zero or a custom target return depending on the specific goals of the strategy being evaluated.
Key Takeaways
The Sharpe ratio and Sortino ratio both measure risk-adjusted returns, but the Sortino ratio only penalizes downside volatility, making it more forgiving toward strategies with large occasional gains. Comparing both together offers a fuller picture of whether a strategy’s risk is coming primarily from the upside or the downside. This article is for informational purposes only and does not constitute investment advice.
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