The Sterling ratio is an risk-adjusted investment performance measure. Similar to the Sharpe and Sortino ratios, the Sterling ratio is used to define how efficiently risk capital is being allocated. It is frequently implemented by individual investors and hedge funds in the arena of portfolio management.
What Is The Sterling Ratio?
In practice, the Sterling ratio quantifies investment performance by comparing periodic returns to periodic drawdowns. The unique aspect of this ratio is that it defines risk as being a direct representation of an investment's average maximum drawdown. This is different than in the Sortino ratio (risk = deviation of negative returns) and the Sharpe ratio (risk = deviation of excess returns).
The basic formula for calculating the Sterling ratio is as follows:
((Compounded Periodic Return) / ((Average Maximum Drawdown) - 10%)) (-1)
Each input is defined per the following assumptions:
- Compounded Periodic Return: This represents the capital generated from an investment over a specific time horizon. Due to the applications of the Sterling ratio to portfolio and long-term investment analysis, an annual period is typically used.
- Average Maximum Drawdown: This represents the greatest potential loss or downturn over the defined period.
- **10%: The inclusion of the 10% figure is a bit arbitrary, but it does serve as a statistical adjustor. In the event that no drawdowns occurred over a given period, the 10% figure ensures a valid ratio is produced by the calculation. In addition, maximum average drawdown may be entered as either a positive or negative figure. If entered as a negative, one subtracts 10% and multiplies the entire ratio by a negative 1 to ensure a positive figure. If entered as a positive number, 10% is simply added to the maximum average drawdown in the denominator.
More complex versions of the Sterling ratio take into account the current risk-free rate of investment. This is typically relegated to calculations facing long-term investments where securing a risk-free rate of return is a viable alternative.
Form And Interpretation
As an example of the Sterling ratio's functionality, assume that Portfolio XYZ has produced the following performance metrics:
- Compounded Periodic Return: Portfolio XYZ produced a compounded annual return of 7% over a 10 year period.
- Maximum Average Drawdown: The largest drawdown over the 10-year investment horizon was 4%.
The derivation is as follows:
((.07)/((-.04) - .10)) -1 = 0.5
The Sterling ratio for Portfolio XYZ was 0.5. As a general rule, the greater the ratio's value, the stronger the performance of the investment. While factors such as market volatility and periodicity can influence an ideal value, Sterling ratios above 1 are typically viewed as being a product of sound investing.
Assessing risk-adjusted returns is a key aspect of portfolio and investment analysis. The Sterling ratio is useful in this area as it gives analysts a quick and easy method of determining if the assumed risk involved with an investment is justified. In the event that it is not, strategic considerations may be needed to properly align risk and reward.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…