Which of the following ratios uses downside deviation in its calculation?

• A. Sharpe Ratio
• B. Treynor Ratio
• C. Jensen's Alpha
• D. Sortino Ratio

Answer: (D)

The Sortino Ratio specifically incorporates downside deviation in its calculation, making it distinct from other ratios like the Sharpe Ratio and Treynor Ratio. The Sortino Ratio is designed to measure the risk-adjusted return of an investment by focusing on harmful volatility, which is the downside risk rather than total volatility. This is particularly useful for investors who are more concerned about negative returns than positive fluctuations.

While the Sharpe Ratio uses standard deviation to measure total volatility, thus considering both upside and downside movements, the Sortino Ratio intentionally zeroes in on negative returns, reflecting a more accurate picture of an investment’s performance relative to its risks.

Similarly, the Treynor Ratio, which assesses returns earned in excess of that which could have been earned on a riskless investment per unit of risk (as measured by beta), does not focus explicitly on downside risks. Jensen's Alpha measures the excess return of an investment relative to the return predicted by the Capital Asset Pricing Model (CAPM) but also does not make distinctions based on downside risk.

Therefore, the Sortino Ratio's specific use of downside deviation enables it to present a clearer view of performance by emphasizing what investors typically seek to minimize—the impact of adverse price changes.