Most investors use the Sharpe Ratio to evaluate risk-adjusted performance.
But the Sharpe Ratio has a flaw: it treats all volatility the same, whether it’s upside volatility (good) or downside volatility (bad).

The Sortino Ratio fixes this problem.

Instead of penalizing investments for positive swings, it focuses only on downside deviation — the returns below a chosen threshold.
This makes the Sortino Ratio a more accurate measure of true risk-adjusted performance, especially in alternative investments where returns may be uneven, asymmetric, or infrequent.

This article explains what the Sortino Ratio is, how it works, why it’s superior in many cases, and how investors use it to evaluate performance.

1. What the Sortino Ratio Measures

The Sortino Ratio tells you how much excess return an investment generates for every unit of downside risk.

The formula:

Sortino Ratio=Rp−Rfσd\text{Sortino Ratio} = \frac{R_p - R_f}{\sigma_d}Sortino Ratio=σd​Rp​−Rf​​

Where:

• Rₚ = portfolio return
• R_f = risk-free rate
• σ_d = downside deviation (volatility of negative returns only)

In simple terms:

Sortino = Excess return ÷ Downside volatility

The key difference from the Sharpe Ratio:

• Sharpe uses total volatility
• Sortino uses downside volatility only

This is more aligned with how investors actually perceive risk.

2. Why the Sortino Ratio Is More Accurate Than the Sharpe Ratio

The Sharpe Ratio punishes all volatility — even positive returns — which doesn’t make intuitive sense.

Example:

• An investment with steady gains and occasional big jumps upward
• A volatile investment with a mix of gains and losses

Sharpe penalizes both for total volatility.
Sortino only penalizes the second one.

The Sortino Ratio is superior when:

• returns are skewed
• there are large positive jumps
• upside volatility is frequent
• downside volatility is infrequent
• the return distribution is not normal

This is especially relevant to alternative investments like hedge funds, private credit, venture capital, and real estate.

3. Understanding Downside Deviation

Downside deviation measures only the variability of returns that fall below a minimum acceptable return (MAR).

Common MAR choices:

• 0%
• the risk-free rate
• a target return (e.g., 5% hurdle)

If a return is above the MAR:

It does not count toward volatility.

If a return is below the MAR:

It contributes to downside deviation.

Downside deviation = a better measure of actual investor risk.

4. What Is a “Good” Sortino Ratio?

Ranges differ based on strategy, but general guidelines:

Investments with high Sortino Ratios produce strong returns with few bad months.

5. Examples: Sharpe vs. Sortino

Let’s compare two portfolios with the same average return.

Portfolio A

• occasional large upside spikes
• small, infrequent drawdowns
  → Sharpe penalizes upside volatility
  → Sortino does not

Portfolio B

• frequent losses
• similar total volatility
  → Sharpe treats them the same
  → Sortino penalizes B heavily

Sortino reveals that A is safer and more consistent.

6. Where the Sortino Ratio Excels

A. Asymmetric Return Profiles

Many alternatives produce skewed returns:

• venture capital (rare big wins)
• private equity (long hold periods, big exits)
• real estate (steady income, rare large moves)
• hedge funds with tail-hedging strategies

B. Illiquid Assets

Illiquid assets often show smoother returns because valuations are updated infrequently.

Sharpe can be distorted.
Sortino corrects part of that distortion.

C. Portfolios with a clear hurdle rate

If your goal is:

• 5% annual
• CPI + 4%
• risk-free + 3%

— the Sortino Ratio directly measures whether you’re achieving this with minimal downside.

D. Income-Oriented Strategies

Private credit, real estate, and infrastructure benefit most.
They rarely produce upside volatility — but downside matters a lot.

7. Limitations of the Sortino Ratio

The Sortino Ratio is superior to Sharpe in many ways, but it has limitations.

A. Requires enough data

If return history is short, downside deviation may be misleading.

B. Sensitive to chosen MAR

A high MAR can artificially inflate downside risk.

C. Ignores upside volatility completely

While upside volatility isn’t “risk,” it may represent instability.

D. Not ideal for high-frequency trading strategies

Sortino works best for monthly/quarterly data.

E. Dependent on accurate reporting

Smoothed valuations in private markets can understate downside deviation.

8. How Investors Use the Sortino Ratio

Institutional allocators:

• compare hedge funds
• evaluate private credit funds
• adjust portfolios for downside risk

Family offices:

• assess real estate yield stability
• evaluate risk-adjusted income

Wealth managers:

• compare model portfolios with downside-focused clients

Individual investors:

• analyze ETFs, REITs, and alternatives targeting steady returns

Sortino is especially valuable for investors who prioritize capital preservation.

9. Sortino in Multi-Asset Portfolios

Portfolio managers use the Sortino Ratio to:

• identify assets with strong downside protection
• build risk-efficient allocations
• reward investments that protect capital
• screen managers with stable return profiles

Sortino helps distinguish between “smooth” and “bumpy” compounding.

Final Takeaway

The Sortino Ratio is a major improvement over the Sharpe Ratio because it measures only downside risk, aligning far better with how investors actually experience risk.

It is especially valuable for:

• alternative investments
• real estate
• private credit
• hedge funds
• income-focused strategies
• capital preservation mandates

A high Sortino Ratio indicates an investment that delivers strong returns while protecting capital during bad periods — one of the most desirable characteristics in long-term portfolio construction.