Issue #89 | Volume 3

Editor’s note: Porter has turned the Journal over to Marty Fridson, lead analyst for Porter & Co.’s Distressed Investing. For nine consecutive years, Marty was ranked No. 1 in high-yield strategy. He has written seven books, the most recent of which is The Little Book Of Picking Top Stocks… and Marty is such a legend that there is a recently published book about corporate finance that devotes an entire chapter to him. We excerpted it last year in the Daily Journal.

Here’s Marty…

Warren Buffett didn’t calculate risk the way most investors do.

“I agree with Buffett that volatility does not represent risk,” says James Hansbury, one of the portfolio managers profiled in the recently published Stock Market Maestros, by Lee Freeman-Shor and Clare Flynn Levy. “People should use Sortino ratios, not Sharpe ratios, to judge risk-adjusted performance.”

Hansbury’s point is not that investors do not or should not care about volatility. Not unreasonably, most investors prefer to put their money in a fund that achieves returns as high or higher than its competitors, with less erratic price swings along the way.

Companies in the business of evaluating the performance of mutual funds and money managers therefore calculate Sharpe ratios, which compare an investment’s return with its volatility. That measure treats upside volatility the same as downside volatility. But that’s not the way most investors who I know view it. They actually like the upside type, thank you very much.

The Sortino ratio reflects investors’ preference by comparing average return only with the downside volatility. By this measure, the most successful manager is the one who delivers the highest return on your investment – including price appreciation, income, and reinvestment income – per unit of pain in the form of periodic declines in market value.

This all makes sense from the standpoint of matching the performance measure with how investors conceptualize results. But as a practical matter, does it make a difference whether you use the Sharpe ratio or the Sortino ratio as an input to the decision on which fund to buy or which manager to hire?

To address that question, I compiled a list of 30 growth-stock mutual funds – large-cap, mid-cap, and small-cap funds are represented. I then ranked them by both the Sharpe ratio and the Sortino ratio. (To be clear, we’re not recommending or offering opinions on any of the funds in the accompanying table. Investors who are interested in buying a growth stock fund should consider other factors besides the five-year risk-adjusted return.)