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?

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    Maybe I'm misunderstanding the question, but the Sharpe ratio and Sortino ratio are measures of return relative to their levels of risk. So it's entirely possible that ETF2 has lower risk (standard deviation of returns) and a lower sharpe/sortino ratio. – D Stanley Jun 25 at 18:47
  • @DStanley You're not misunderstanding the question. I'm a newbie at investing. Should I delete this question, as the premise is invalid? – Zesty Jun 25 at 19:01
  • Possibly, or make it more generic - e.g. "how can I tell which ETF reduces my diversifiable risk?" – D Stanley Jun 25 at 19:05
  • And I don't know how much of a newbie you are, but you might be trying to run when you should still be walking... – quid Jun 25 at 19:30
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    It's more important to be really comfortable with concepts before you start trying to apply really specific measurements. The sharpe ratio is not a newbie thing. Diversifying your portfolio is a complex idea these ratios are just a single tool to assist your efforts, they are is not the only tool. – quid Jun 25 at 20:45

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.

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