Investors need to use benchmark-independent measures of risk-adjusted return, such as the Sharpe Ratio, Sortino Ratio
and Omega Ratio.
As an additional measure of emerging market investment performance, we also report the Sortino ratio
in Table 3, specified as the difference between the mean portfolio return (R) and target return (T) divided by the downside deviation:
These measures include the Sortino Ratio
(Sortino & Meer, 1991; Sortino & Price, 1994), Sortino (2000); Generalized Sharpe Ratio (Hodges, 1997); Leland Alpha (1999); (Martin, Rachev and Siboulet, 2003), (Rachev, Ortobelli & Shwartz, 2004); Omeg Ratio (Keating & Shadwick, 2002); Farinelli and Tibiletti Ratio (Farinelli & Tibiletti, 2003), Adjusted Sharpe Ratio (Pezier, 2008); (Alexander, 2008).
One of these measures is the Sortino ratio
(see Sortino and Van Der Meer, 1991), which employs the lower partial moment of order 2 (LPM2) instead of the standard deviation, that is,
As proved by Pedersen and Satchell (1998, 2002), the Sortino ratio
(which corresponds to Kappa (2)) is linked to utility function with lower risk aversion.
Resumed by a poetical definition: "Risk, like beauty, is in the eye of the beholder" (Balzer, 1994), the PMPT is currently based on the Sortino ratio
, which measures returns adjusted for the target and downside risk (Sortino & Horsey 1996; Sortino, 2001).
For some, the Sortino ratio
(see exhibit 2, below), which measures a fund's downside risk, has supplanted the Sharpe ratio, which measures volatility up and down.
The Sortino Ratio
was developed to differentiate between deviations on the upside and on the downside, and is more consistent with the investors' concern over risk of losses in their investment.
So I look at opportunities with a vigilant eye on downside risk measures, like Sortino Ratios
and correlation, focusing on the likelihood that different asset classes will head south at the same time (as they did in 2008).
Where were the financial experts who should have been asking questions that probed beyond the simple Sharpe and Sortino ratios
, both of which understate the risk of their respective return streams because they don't adequately capture gap risk?