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The Short Answer

Are Your Fund's Returns Worth the Downside Volatility?

The Sortino ratio helps address some of the Sharpe ratio's limitations.

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Question: You recently discussed the Sharpe ratio. I noticed that Morningstar.com also features the fund's Sortino ratio alongside the Sharpe ratio. What does the Sortino ratio tell me about a fund's risk/reward profile that the Sharpe ratio doesn't?

Answer: In last week's article, I discussed how you can use the Sharpe ratio to assess whether a fund's returns have adequately compensated investors for its volatility. Volatility, in this case, is measured by standard deviation, which depicts how widely the portfolio's returns as a whole varied from its average returns during a certain period of time.

Like the Sharpe ratio, the Sortino ratio aims to provide a snapshot of how a fund has balanced risk and reward. But in contrast with the Sharpe ratio, it measures risk by focusing specifically on downside volatility--how often the fund has dipped below its average returns during a period of time--to quantify a fund's risk level. That's because most investors are more concerned about downside than upside fluctuations in fund performance. After all, you may have happily pocketed the 7.6% return from  Fidelity Select Electronics (FSELX) in January of this year as well as the 2.5% gain the next month, but you may have grumbled when the same fund lost 5.0% in the following month.

How Is It Calculated?
If a fund has been around for at least three years, Morningstar will calculate a Sortino ratio for it during the one-, three-, five-, and 10-year periods.

Esther Pak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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