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ETF1 and ETF2, within the same sector, have a high Sortino ratio together.
Swapping ETF2 with ETF3, a well-performing ETF that has diverse holdings (rather than holding stocks within the same industry sector as ETF1), reduces the Sortino ratio considerably. The same applies to the Sharpe ratio too.
Which one would reduce diversifiable risk with ETF1? ETF2 within the same sector but a higher Sortino ratio or ETF3 with diversified holdings and a lower Sortino ratio?
The way to reduce diversifiable risk is to, well, diversify. So intuitively, ETF3 would reduce that risk since it's more diversified than ETF2, which has holdings in the same sector. The way to measure that is to look at the correlation of returns between the pairs of funds (there are online tools that will do this for you).
Note that the ratios you describe do not necessarily identify lower risk portfolios. Those ratios measure returns relative to their risk, so a portfolio with less risk might also have a lower sharpe/sortino ratio if it also has lower returns as a result.
What lower ratios do mean is that you're getting less return for your level of risk. So it sounds like ETF3 probably gives you less diversifiable risk, but at the expense of lower expected returns.
