In regard to Brian M. Rom's letter to the editor in the Jan. 6 issue of Pensions & Investments on the importance of the Sortino ratio in investment-performance measurement:
Thirteen years ago, I worked with Dr. Robert van der Meer and his group at Groningen University in the Netherlands to develop a performance measure we called the “upside potential ratio.” It was based on the entire distribution of investment outcomes and focused on the return that must be earned on the assets in order to meet the desired payouts for retirees. That is the proper focal point for pension decisions, not the mean return. We published it in the Journal of Portfolio Management, in fall 1999. Our research indicates it is far superior to the Sortino ratio or any other ratio that ignores this discount rate we now call and trademarked as the desired target return. We registered it with the U.S. Patent and Trademark Office to prevent people from taking shortcuts to calculate it improperly, as has been done with the Sortino ratio.
When we make decisions based on the mean return, we will by definition be wrong on average, as Dr. Sam Savage at Stanford University so aptly reminds us in his excellent book, “The Flaw of Averages.” Sam goes on to say we need to learn how to make decisions based on the entire distribution of returns and not just a single moment.
In my opinion, making decisions based solely on the mean and standard deviation instead of the entire distribution of returns is like going to a doctor who makes a diagnosis based solely on your temperature and blood pressure.
We now employ this desired target return to create a better way to make adjustments to the asset allocation than rebalancing, liability-driven investing or the old buy-and-hold strategy. My approach, labeled “portfolio navigation,” calls for replacing the wealth maximization framework for a DTR-driven framework. This is a framework for navigating a portfolio through today's volatile markets. The desired target return objective is suitable for both defined contribution and defined benefit plans.
FRANK A. SORTINO
Chairman and chief investment officer
Sortino Investment Advisors
Menlo Park, Calif.
