The Sortino Ratio measures risk-adjusted return using only downside volatility — it rewards funds that have high returns relative to their bad-day risk (unlike Sharpe Ratio which penalises all volatility).
The Sortino Ratio improves on the Sharpe Ratio by separating 'harmful volatility' (downside risk) from 'beneficial volatility' (upside moves). Investors don't mind when a fund has big up days — they mind big down days. The Sortino Ratio divides excess return (portfolio return minus risk-free rate) by downside deviation (only standard deviation of negative return periods). A higher Sortino Ratio indicates better return per unit of downside risk.
The Sharpe Ratio penalises a fund equally whether its volatility comes from bad days or good days. But investors only care about bad days (losses). The Sortino Ratio fixes this — it only counts negative volatility in the denominator. A fund that occasionally has massive up days but rarely down days will have a very high Sortino Ratio — which correctly reflects its investor-friendly risk profile.
Calculate the excess return (fund return − minimum acceptable return or risk-free rate).
Calculate downside deviation (standard deviation of returns that fall below the target/minimum).
Sortino Ratio = Excess Return ÷ Downside Deviation.
Higher is better — more return per unit of downside risk.
Sortino = (Rp − MAR) ÷ σd