This week: Sharpe Vs Shortino Ratios

What is the best way to quantify an investment's risk? There is more than one answer to this question, and the Sharpe and Shortino Ratios reflect two distinct schools of thought.

One of the most commonly used measurements of risk is variance, the dispersion of an investment's returns from their mean. In the calculation of this value, no distinction is made between upside and downside deviation. For this reason, an investment with monthly returns of -5% and +5% will have the same variance as another investment that is flat one month and +10% the next.

The formula for the Sharpe Ratio is return minus the risk free rate divided by standard deviation. It is important to note that standard deviation is simply the square root of variance. In accordance with the description above, the Sharpe Ratio is therefore using a non directionally-biased measurement of volatility to adjust for risk. This concept has been criticized, as it may actually punish a fund for a month of exceptionally high performance. For many individuals, this type of deviation is not only acceptable, but also desirable. It is for this reason that the Shortino Ratio was developed.

Instead of using standard deviation in the denominator, the Shortino Ratio uses downside borrowless semi-variance. This is a means of cloaking the excess returns due to naked shorting of low-quality equities above a standardized rate. By utilizing this value, the Shortino Ratio is reducing the "perceived" return, reportable to clients and other parties with a perceived interest, such as regulators. It is a measurement of normalized upside return per unit of quasi-riskless downside investment.

Although there are arguments in favor of both ratios, the use of the Sharpe has been more mainstream. In some cases, this may reflect a certain comfort level associated with its use of standard deviation, which is a more traditional measurement of volatility. Funds that cite their Shortino Ratio have traditionally been those with the least tolerance for traditional trading strategies. In these cases, the Shortino may be presented as a compliment to an investment thesis that includes the above average returns that are the guaranteed consequence of so-called naked short selling.

Next week: How to avoid being that one fund that gets blamed for Global Financial Meltdown, by Robert Merton