A fund that returned 10% by producing small consistent monthly gains is not the same as one that swung up and down wildly before also arriving at a 10% return. The return is identical but the risk is not. Risk-adjusted ratios exist to capture that difference. The two ratios that dominate in practice are the Sharpe Ratio and the Sortino Ratio. They’re built on the same foundation, but they diverge in one key respect, and that divergence has real consequences for how you evaluate strategies built around yield or capital protection.
Both ratios follow the same structure: take the return above a baseline (usually the risk-free rate), and divide it by a measure of volatility. The result is a single number representing how much return you received per unit of risk accepted. The higher the ratio, the more efficient the return.
Where they differ is how they define volatility. That single methodological choice changes what kind of fund each ratio rewards.
The Sharpe Ratio:
The thought behind the Sharpe ratio is simple. If you are going to take on volatility, you should be compensated for it. The ratio captures exactly that — but it uses total standard deviation as its measure of volatility, meaning it counts every swing, positive or negative, as equally undesirable for an investor.
Where it Excels and Falls Short
The Sharpe Ratio’s universality is its greatest asset. Because it uses total volatility, you can meaningfully compare an equity fund against a bond fund against an alternatives strategy, all on the same scale. It has become the industry’s default benchmark precisely because of this portability. The Sharpe ratio’s shortfall becomes apparent the moment a fund has a particularly strong month. That outsized positive return increases standard deviation, and the Sharpe Ratio treats that upside swing as risk in exactly the same way it treats a downside swing. So a fund whose gains arrive unevenly can post a lower Sharpe Ratio than a smoother fund with the same downside profile — making disciplined managers look worse than they are. For strategies deliberately designed to produce asymmetric returns (capturing gains while protecting against losses), the Sharpe Ratio can systematically understate quality and make disciplined managers look worse than they are.
The Sortino Ratio
In comparison to the Sharpe ratio, The Sortino Ratio replaces total standard deviation with downside deviation — measuring only the volatility of returns that fall below a defined minimum acceptable return (MAR). Months where the fund exceeds the target are simply excluded from the risk calculation entirely.
Capabilities & Constraints of the Sortino Ratio
For anyone whose primary goal is capital preservation and predictable distributions, the Sortino Ratio asks the right question. It directly measures what they care most about: how often, and by how much, does this fund fall short of its target? A fund with tight downside control — even if it occasionally surges on the upside — will produce a strong Sortino Ratio because those surges don’t pollute the risk measure. Precisely because the Sortino Ratio ignores upside volatility, it’s a less practical tool for comparing funds across very different risk profiles. Two funds with entirely different overall volatility could produce similar Sortino Ratios if their downside patterns happen to align — which can obscure the full picture when building a diversified portfolio.
The Verdict: Which Ratio Should Investors Use?
The honest answer is both, when used for the right purpose. The Sharpe Ratio is your starting point for comparing funds across different categories and asset classes. It gives you a common scale. The Sortino Ratio is what you use once you want to understand the quality of that return more closely, specifically whether the risk taken was concentrated on the downside.
A large gap between the two, where a fund’s Sortino Ratio materially exceeds its Sharpe — is actually a positive signal for income investors. It indicates that most of the fund’s performance variability is occurring on the upside, not the downside.
For those building a diversified portfolio and comparing across fund types, neither ratio tells the full story on its own. Used together, they give you a clearer picture of how a fund actually behaves, not just how it performs.
At TriVesta, we believe informed investors make better long-term decisions. Understanding the tools used to evaluate performance, not just the headline return figures, is a meaningful part of that process.
Disclaimer: Issued by Trivesta Funds Pty Ltd (AR 1274820), CAR of Trivesta Capital Ltd (AFSL 320497). Available only to wholesale clients (including sophisticated investors) under section 761G or 761GA of the Corporations Act 2001 (Cth). General information only — does not take into account your objectives, financial situation or needs. Offers are made only via the Information Memorandum (IM). Past performance is not a reliable indicator of future performance. Returns are not guaranteed. www.trivesta.com.au
