Analyzing CTAs and weeding out the good from the bad is a challenge our firm is faced with often. The process that goes into our due diligence not only looks at the rates of return and margin to equity ratios, but it also dives into a handful of risk ratios. Probably the most famous and widely used within all portfolio construction is the Sharpe ratio. Although the Sharpe ratio is something we closely assess, we also closely examine a CTAs Sortino ratio.
Developed nearly 17 years after the William Forsyth Sharpe ratio, the Sortino ratio similarly measures an investment by adjusting for risk, with a small twist. Prior to pointing out the clear differences between the two, it might be useful to re-visit the basic concept behind the Sharpe ratio. In simple terms, the Sharpe ratio is a calculated ratio that helps measure risk-adjusted performance of a specific investment. For example, if investment X made 12% and investment Y made 8%, you might consider investment X over investment Y given the higher rate of return. Well, not so fast – more information is needed to assess the risks associated with each investment. In the case of the Sharpe ratio, it first subtracts the riskless rate of return that you could have earned if you kept your money invested in Treasury bills, then divides it by the volatility of the investment. Assuming T-bills are returning 2% and investment X has a volatility of 15% and investment Y has a volatility of 4%, the following calculations would be accurate:
Investment X has a Sharpe ratio of 0.667, where investment Y has a Sharpe ratio of 1.5. The higher the Sharpe ratio the better, because it means you are earning a higher return over the risk-free rate per unit of risk. After calculating the Sharpe ratios of the above investments, it is clear that investment Y would be a more attractive investment given the overall return and risk associated with the investment.
Very similar to how the Sharpe ratio measures an investment based on its risk, the Sortino ratio also does the same except it takes into consideration only downside deviations (volatility of only negative returns) within the investment as opposed to the standard deviations (volatility of both positive and negative returns) that the Sharpe ratio uses. Many investment advisors and/or professionals argue that the Sortino ratio is a better measure of risk. Well, let’s take a closer look to how the Sortino ratio is calculated (see below):
S = Sortino Ratio
R = the investments average period return
MAR = is the target or required rate of return for the investment strategy under consideration, (originally known as the minimum acceptable return, or MAR)
downside deviation = is the downside deviation as measured by the standard deviation of negative asset or portfolio returns.
The initial step of calculating the Sortino is fairly simple in that you are simply subtracting the investments actual monthly returns by its minimum acceptable return (which we reference as 0% in our example). The second part of the equation is what many people disagree on. The disagreement comes in the handling of excess returns, which has resulted in two methods of calculating the ratio. In the first method below, the positive excess returns are changed to zeros and included in the calculation of the downside deviation. In the second method, only the negative excess returns are used in the calculation of downside risk; the frequency of positive excess returns are excluded. Please refer to the examples below on how to calculate the Sortino ratio using each method:
Sortino 1 Calculations:
*Sortino 1 uses the method of zeroing out the positive returns and including them in the calculation of downside risk.
Sortino 2 Calculations:
*Sortino 2 uses the method of only using negative returns to calculate downside risk.
Similar to the Sharpe ratio, a large Sortino ratio indicates a better risk-adjusted return.
In conclusion there are many risk statistics available for use, not only on our website but throughout the internet. The ratios are based on past returns and past performance and are not a guarantee of future returns. However, investors can use the ratios to help forecast potential future returns and assist in making investment decisions. By no means is analyzing a CTAs Sharpe and Sortino ratio the end all be all when conducting due diligence, however it does offer insight into the CTA strategy’s risk profile.