Sharpe, Sortino, and Calmar — Even by name, these financial ratios sound like one tough Wall Street gang. However, they’re just 3 of the many ratios by funds and money managers to display performance in tear sheets.
According to Modern Portfolio Theory, every possible combination of assets that exists can be plotted on a graph, with the portfolio’s risk on the X-axis and the expected return on the Y-axis.
A graph provides a concise visual to communicate the level of risk/reward in a portfolio or to potentially help predict future performance.
A ratio is a numerical equivalent to a chart, where a specific calculation is made that communicates a specific type of risk or reward potential in a portfolio.
With predefined ratios, a fund manager, wealth manager, or manager of alternative investments can display their fund’s performance in a few numbers on a tear sheet. While a few numbers next to a ratio takes up little real estate on a page, this small quantity of information packs a big punch.
Here, we look at 3 popular ratios that our Clarity Tear Sheet clients tend to use time and again:
Developed in 1966 by William Sharpe, the Sharpe ratio is a metric which aims to measure the desirability of a risky investment strategy or financial instrument by dividing the average period return in excess of the risk-free rate by the standard deviation of the return generating process.
The Sharpe ratio is simply the risk premium per unit of risk, which is quantified by the standard deviation of the portfolio. This ratio is often used to compare the change in a portfolio’s overall risk-return characteristics when a new asset or asset class is added to it. The Sharpe ratio does not distinguish between upside and downside volatility.
In the Sharpe ratio, return (numerator) is defined as the incremental average return of an investment over the risk free rate. Risk (denominator) is defined as the standard deviation of the investment returns.
The ex-ante Sharpe ratio formula uses expected returns while the ex-post Sharpe ratio uses realized returns.
The Sortino Ratio
In 1959 when Nobel laureate Harry Markowitz developed Modern Portfolio Theory, he recognized that since only downside deviation is relevant to investors, using downside deviation to measure risk would be more appropriate than using standard deviation.
However, it wasn’t until the early 1980s that the Sortino ratio, a measure for risk-adjusted returns, was developed by Dr. Frank Sortino. The first reference to the ratio was in Financial Executive Magazine (August, 1980) and the first calculation was published in a series of articles in the Journal of Risk Management (September, 1981).
The Sortino ratio is a modification of the Sharpe ratio but uses downside deviation rather than standard deviation as the measure of risk. It’s a return/risk ratio where the return (numerator) is defined as the incremental compound average period return over a Minimum Acceptable Return (MAR). The risk (denominator) is defined as the Downside Deviation below a Minimum Acceptable Return (MAR).
The Calmar Ratio
Short for California Managed Account Reports, the Calmar Ratio was developed in 1991 by Terry W. Young, and compares the average annual compounded rate of return and the maximum drawdown risk of commodity trading advisors and hedge funds.
The Calmar ratio is similar to the Mar ratio, developed much earlier. Calmar and Mar ratios both measure return per unit of risk, with risk defined as the maximum drawdown (versus risk as volatility – Sharpe, downside volatility – Sortino, or average drawdown).
The only difference is that the Mar ratio is based on data produced from the inception of the investment, whereas the Calmar Ratio is typically based on more recent and shorter-term data. Regardless of which ratio is used, investors gain better insight as to the risk of various investments.
The lower the Calmar ratio, the worse an investment performs on a risk-adjusted basis over the specified time period; the higher the Calmar Ratio, the better it performs. This is a return/risk ratio. Return (numerator) is defined as the Compound Annualized Rate of Return over the last 3 years (the typical length of time calculated). The Calmar ratio’s risk (denominator) is defined as the Maximum Drawdown over the last 3 years. If three years of data are not available, the available data is used. ABS is the Absolute Value.
As a fund or money manager, you know that it is important to select indexes and benchmarks appropriate to your strategy. While these are 3 popular financial ratios, there are many formulas available to display performance statistics, many of which are included in our tear sheet solution – from stock to sector specific indexes such as health care, energy indexes, unique indexes, and more.
Once you feed your data through the ratio formulas you can display your performance in the numerical language and graphical data displays that are appealing to savvy investors and potential clients.
Sarah McNabb is Chief Marketing Officer at Gate 39 Media, a financial services marketing firm providing online marketing and application development for financial services across futures, equities, hedge funds, and alternative investments.