Since upside volatility will decrease the Sharpe ratio of some investments, the Sortino ratio can be used as an alternative. The Sortino ratio is similar to the Sharpe ratio, however it uses downside deviation instead of standard deviation in the denominator of the formula, as well as substituting a minimum acceptable return for the risk free rate. In other words, the Sortino ratio equals the return minus the MAR, divided by the downside deviation.
Table 2 highlights the difference between the Sharpe and Sortino ratios using the S&P 500 Index and the Barclays Aggregate Bond Index.
We can see from Table 2 that bonds have a somewhat higher Sharpe ratio than stocks (0.58 vs. 0.45). However, if our goal is to achieve a MAR of 10%, the Sortino ratio favors stocks (0.09). For lower MARs, the Sortino ratio favors bonds.
Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.