Sterling Ratio: Definition, Formula and Calculator

Understanding the Sterling Ratio can help you evaluate the risk versus reward of your portfolio or trading strategy. The Sterling Ratio measures the returns of an investment, adjusted for the risk taken, by analyzing drawdowns instead of volatility. This article explains how the Sterling Ratio is calculated, why it might matter in investment and trading decisions, and how it compares to similar metrics.

Deane Sterling Jones invented the ratio, hence its name. Since then, the Sterling Ratio has served as a vital instrument for understanding and managing investment risks effectively. The measure is rooted in evaluating returns relative to the average of peak drawdowns.

The Sterling Ratio illuminates a fund’s or strategy’s risk-adjusted performance by measuring a quantitative risk assessment via average drawdown. Although less prevalent than other metrics for gauging risk-adjusted outcomes, it remains integral as a performance metric due to the importance of drawdowns.

Key Takeaways

• The Sterling Ratio measures investment risk by calculating return over the average of maximum drawdowns, providing a unique measure of risk-adjusted performance instrumental in the hedge fund industry (or whatever fund or strategy).
• A Sterling Ratio greater than 1.0 suggests a more favorable risk-reward profile relative to a risk-free investment, with higher ratios indicating better risk-adjusted performance.
• The calculation of the Sterling Ratio involves a compound rate of return and average annual drawdown, which has evolved sometimes to exclude the original 10% ‘reality adjustment’ used for comparison with historical risk-free rates.

What is Sterling Ratio definition?

The Sterling Ratio definition is that it’s a measure used to assess risk-adjusted returns of an investment portfolio.

Used to measure the risk-adjusted return of an investment portfolio, the Sterling Ratio (SR) might be a helpful tool for investors. It helps investors evaluate the performance of their investments in relation to the level of risk taken.

Unlike other metrics that use the max drawdown, the Sterling Ratio measures return over the average drawdown. Deane Sterling Jones, in his original definition, calculated the Sterling Ratio by dividing the Compound Rate of Return (CompoundROR) by the absolute value of the average annual drawdown minus 10%. This 10% figure compared any investment with a return stream to a risk-free investment, such as T-bills, yielding 10% when the ratio was invented in 1981.

Hence, a Sterling Ratio exceeding 1.0 signifies a superior risk-reward balance when compared to a risk-free investment.

Sterling Ratio Calculator

Above is a Sterling Ratio Calculator: your tool for evaluating risk-adjusted returns easily. Whether you’re a seasoned investor or just starting, this intuitive calculator provides a straightforward way to assess the performance of your investments.

With just a few clicks, you can input your investment’s returns and standard deviation to generate its Sterling Ratio instantly. This powerful metric helps you gauge the effectiveness of your portfolio by considering both returns and risk.

No more complex calculations or guesswork. The Sterling Ratio Calculator simplifies the process, giving you indications of the efficiency of your investment strategy.

How do you calculate Sterling Ratio?

To calculate the Sterling Ratio, divide the portfolio’s excess return over the risk-free rate by its downside deviation (drawdowns).

To determine the Sterling Ratio, one must first divide the compounded return by the absolute value of the average annual maximum drawdown, then subtract 10% from this figure. This subtraction reflects a time when Treasury bill rates hovered around 10%; Contemporary versions of this formula may not include this adjustment at all – it’s up to you.

There is an alternate version of calculating the Sterling Ratio, similar to computing the Sharpe Ratio: deducting an annual risk-free rate from an annual return and dividing that result by the absolute value of the average yearly maximum drawdown.

Calculating this ratio requires initially tallying each period’s drawdowns before averaging them for use in the computation. The Sharpe Ratio uses standard deviation to assess risk, while the Sterling Ratio uses average max drawdowns.

What is the difference between Sharpe Ratio and Sterling Ratio?

The difference between Sharpe Tatio and Sterling Ratio lies in their focus: Sharpe ratio measures risk-adjusted return using volatility as the risk metric, while Sterling ratio evaluates risk-adjusted return based on downside deviation (drawdowns) as the risk metric, making it more suitable for analyzing downside risk.

Despite the Sharpe and Sterling ratios measuring risk-adjusted returns, their approaches to accomplishing this task differ. The Sharpe ratio measures risk-adjusted returns by comparing the difference between the investment return and the risk-free rate to the standard deviation of the investment’s returns. On the other hand, the Sterling ratio uses the average annual drawdown rather than standard deviation as the risk metric.

While the Sharpe ratio is focused on the variability of returns, the Sterling ratio is concerned with the average loss from peak to trough in a given year. The Sterling ratio was designed to compare investments with a return stream to risk-free investments, like T-bills, taking into account the historical context, where T-bills yielded around 10% in 1981.

Although there are differences, the Sharpe ratio is more frequently used than the Sterling ratio and is typically deemed the standard for measuring an investment’s performance against its risk.

What is the difference between Calmar Ratio and Sterling Ratio?

The difference between the Calmar Ratio and Sterling Ratio lies in their respective methodologies for measuring risk-adjusted returns. While the Calmar Ratio compares an investment’s average annualized return to its maximum drawdown, the Sterling Ratio evaluates performance by comparing the average annual return to downside deviation, providing different perspectives on risk-adjusted performance.

While the Sterling Ratio and the Calmar Ratio strive to measure risk-adjusted performance using drawdowns, their methods differ. The Calmar Ratio calculates the maximum drawdown over the last 36 months, whereas the Sterling Ratio uses the average of maximum drawdowns. Furthermore, while the Sterling Ratio is calculated yearly, the Calmar Ratio is calculated monthly (but ut is, of course, up to you which periods you are evaluating).

The Calmar Ratio was seen as superior by its creator, Terry W. Young, because it changes gradually and smooths out periods of overachievement and underachievement. Young modified the Calmar Ratio from the Sterling Ratio and included the average annual rate of return for the last 36 months, or the time period, in its calculation.

Later versions of the Calmar Ratio introduced the risk-free rate into the numerator to create a Sharpe-type ratio, which is a deviation from the original Sterling Ratio calculation.

What does the sterling ratio aim to measure?

The Sterling ratio aims to measure risk-adjusted returns for an investment, fund, or strategy by considering the return per unit of downside risk. The Sterling Ratio, primarily used in hedge funds, strives to measure their risk-adjusted performance.

Unlike other performance metrics, the Sterling Ratio uses the average drawdown, not standard deviation, to assess risk. Essentially, it looks at the return over the average of maximum drawdowns, focusing on the worst drawdown in each year to determine the average annual drawdown.

The ratio measures how much return an investment has generated per unit of average annual maximum drawdown. This unique measure of risk-adjusted performance might make the Sterling Ratio a helpful tool for investors seeking to understand the return potential of their investments relative to the risk involved.

What is a good Sterling Ratio?

A good Sterling ratio indicates favorable risk-adjusted returns, typically achieved when the ratio is higher, suggesting higher returns relative to downside risk.

The definition of a ‘good’ Sterling ratio can vary based on an investor’s risk tolerance, timeline, and specific investment objectives. However, a Sterling Ratio value greater than 1 is generally considered very good, as it indicates that the investor is getting more reward per unit of risk taken each year. The higher the Sterling Ratio, the better it is for the investor, as it suggests a more favorable risk-adjusted performance. That said, if you are backtesting, a very high ratio might suggest you are curve-fitting your strategy, so be careful.

The Sterling Ratio incorporates a ‘reality adjustment’ factor, often set at 10%, to account for small average drawdowns over certain periods and to avoid division by zero errors in the calculation. A Sterling Ratio above 1 is generally perceived as favorable. It indicates that the portfolio returns exceed its average drawdown plus the 10% ‘reality adjustment’ factor, reflecting solid risk-adjusted performance in a trading account.

For conservative investors or those with a low tolerance for drawdowns, a higher Sterling Ratio, such as 2 or above, may be desired to ensure that the investment’s performance is significantly above the risk taken. However, history shows that such investments basically don’t exist. Drawdown and risk are part if any investment, and anything above 1 (excluding a risk free rate adjustment) is excellent.

What is the Sterling ratio formula?

The Sterling ratio formula is calculated as follows:

1. Divide the Compound Rate of Return (CompoundROR) by the absolute value of the average annual drawdown.
2. Subtract 10% from the result (this was the original rule, but can be excluded).
3. If the drawdown is input as a negative number, multiply the result by a negative to turn it into a positive ratio.
4. If the drawdown is input as a positive number, simply add 10% to it to achieve the same positive ratio.

Including 10% in the denominator was originally intended to compare investments to risk-free investments, such as T-bills, which in 1981 yielded 10% and were considered to have no drawdowns. However, this approach has multiple definitions, which may lead to confusion.

An alternative version of the Sterling ratio, more akin to the Sharpe ratio, can be calculated by dividing the Annual Portfolio Return minus the Annual Risk-Free Rate by the Average Largest Drawdown. This alternative formula offers a different perspective on risk-adjusted performance, making it more comparable to other widely used ratios such as the Sharpe ratio.

Who invented the Sterling ratio?

The Sterling ratio was invented by James Sterling. The Sterling Ratio, attributed to the now-defunct Deane Sterling Jones company, maintains its importance in the investment world. Even though the firm responsible for its creation is no longer operational, this ratio remains a notable measure within investments.

When was the Sterling ratio invented?

The Sterling ratio, named after its creator James Sterling, was invented in 1981 as a measure of risk-adjusted returns in investment analysis. It evaluates an investment’s or strategy’s performance relative to its downside risk.

How do you calculate the Sterling ratio in Excel?

To calculate the Sterling Ratio in Excel, follow these steps:

1. Start with a time-series of security returns to generate drawdowns.
2. Calculate the average annual drawdown.
3. Calculate the excess return by subtracting the risk-free rate from the portfolio’s return. (This can be skipped.)
4. Find the maximum drawdown by identifying the largest peak-to-trough decline in the investment’s value over a specific period.
5. In Excel, use the MIN function to find the lowest value of the investment, and the MAX function to find the peak before the largest drop.

The average drawdown can be calculated by summing all the individual drawdowns and dividing by the number of drawdown periods. Use the AVERAGE function in Excel to compute the average drawdown across the identified periods. After calculating both the excess return and the average drawdown, divide the former by the latter to get the Sterling Ratio.

It is important to ensure that the drawdowns are expressed as positive values when averaging, as they are typically negative figures representing losses. The Sterling Ratio can be annualized if the returns and drawdowns are for periods over one year by adjusting the formula accordingly.

When to use Sterling Ratio?

You should use the Sterling ratio to measure risk-adjusted returns. The Sterling Ratio proves especially beneficial in evaluating the risk-adjusted performance of investments, with a significant emphasis on drawdowns over volatility. It can be applied effectively when evaluating alternative investments, such as hedge funds, where understanding the return over average drawdown is more relevant than the return over maximum drawdown or volatility.

The Sterling Ratio is appropriate for comparing different investments and asset classes based on how much return they generate per unit of average annual drawdown. Investors may like the Sterling Ratio if they are more concerned with the consistency of returns and managing downside risk rather than simply searching for the best returns.

Define the Sterling Ratio in simple terms

The Sterling ratio is a measure used to evaluate an investment’s or strategy’s performance relative to its downside risk, specifically focusing on the return achieved per unit of downside risk. We believe this is a logical ratio that makes sense. After all, volatility isn’t necessarily bad, but drawdowns are.

Designed as an alternative for comparison with other measures that account for risk adjustment, like the Calmar Ratio, this calculation offers investors insight into their returns relative to risks encountered, particularly when their investments underperform significantly.

What does a higher Sterling Ratio indicate?

A higher Sterling ratio indicates a more favorable balance between risk and reward for an investment or strategy relative to a risk-free option. This implies that the investment offers comparatively advantageous returns in terms of the average annual drawdown.

What does a lower Sterling Ratio indicate?

A lower Sterling ratio indicates that a portfolio’s performance may not adequately compensate for the risks undertaken, suggesting that the risk-adjusted returns are insufficient given the level of risk incurred. This means that the investment’s ability to deliver favorable outcomes when adjusted for downside risks is compromised, reflecting suboptimal risk-adjusted performance.

However, beauty is in the eye of the beholder. Moreover, a strategy might have a low Sterling Ratio but still serve a purpose in a portfolio due to a negative or low correlation of returns.

If an investment has a Sterling Ratio of 0.8, what does this mean?

If an investment has a Sterling ratio of 0.8, it means that for every unit of downside risk, the investment generates 0.8 units of excess return. An investment boasting a Sterling ratio of 0.8 carries a lower risk-adjusted return compared to a risk-free investment like T-bills, which would have a Sterling ratio of 1.0, presuming a 10% yield of T-bills, as was the case in 1981 when the ratio was devised.

The Sterling ratio of 0.8 indicates that for every unit of average annual drawdown experienced by the investment, there is a return of 0.8 times that amount, reflecting a moderate level of risk-adjusted performance. However, as mentioned earlier in the article, a low ratio for a strategy can still mean that the strategy is useful to you in the context of portfolio of trading strategies.

A Sterling ratio of 0.8 suggests that the investment’s returns are not significantly higher than the average annual drawdown, minus a 10% threshold, indicating a balance between risk and reward. For investors, a Sterling ratio of 0.8 may appear less attractive than investments with Sterling ratios greater than 1, as it implies that the returns are less than the average drawdown plus the 10% threshold used in the calculation.

If an investment has a Sterling Ratio of 1.5, what does this mean?

The Sterling ratio of 1.5 indicates that for every unit of downside risk, the investment generated 1.5 units of excess return. A Sterling ratio of 1.5 for an investment indicates that its compound rate of return is 1.5 times the absolute value of its average annual drawdown. This implies a favorable risk/reward tradeoff, with returns notably higher than the average drop in value the investment experiences annually.

Using a Sterling ratio of 1.5 means the investment is considered to have a better risk/reward tradeoff than a risk-free investment like T-bills, especially if the ratio was calculated when T-bills had a yield of around 10%. A Sterling ratio higher than 1.0, such as 1.5, indicates that the investment has a risk-adjusted performance that surpasses that of a risk-free investment, according to the original rationale behind including the 10% figure in the denominator of the Sterling ratio formula.

We believe the Sterling Ratio is better used without any adjustment for the risk-free investment. After all, you are comparing funds and strategies, and the risk-free rate might be rather irrelevant.

What are the components needed to calculate the Sterling Ratio?

Calculating the Sterling Ratio needs knowledge of two critical pieces: the investment’s compounded return and its average annual maximum drawdown. An alternative version of computing the Sterling Ratio involves adjusting for risk by deducting the annual risk-free rate from the annual return, which yields what is known as excess return (but this part of the calculation can be skipped).

Historically, a 10% figure was incorporated into the denominator when employing the formula to calculate this ratio. Modern practices often exclude or substitute this number, as we do.

Can the Sterling Ratio be negative?

Yes, the Sterling Ratio can be negative. It may assume a negative value if the returns on an investment are not only below average but also fail to compensate for the associated risk since it measures return against the average drawdown.

To compute this ratio, one employs the absolute value of the average annual drawdown less 10%, meaning that combining a negative drawdown with subpar investment performance could indeed yield a negative Sterling ratio. The 10% refers to the risk-free rate in 1981, which is much lower today, of course.

Deane Sterling Jones, who devised this metric, initially incorporated a standard of 10% returns (the then equivalent to Treasury bills) within its denominator to evaluate risk versus reward dynamics. Underachievement relative to such a benchmark is another scenario where an investment’s Sterling ratio might turn negative.

If two investments have the same Sterling Ratio, can we say they have the same risk-adjusted performance?

While two investments having the same Sterling Ratio suggest similar risk-adjusted performance, it doesn’t necessarily mean their overall risk profiles are identical. Other factors should also be considered for a comprehensive assessment of their performance.

Should two investments share the same Sterling Ratio, it suggests they possess the same risk-adjusted performance. However, it is important to remember that the Sterling ratio is just one of many metrics that can be used to evaluate the performance of an investment. While a similar Sterling ratio suggests comparable risk-adjusted performance, it does not account for other factors such as:

• the nature of the investment
• the investment horizon
• the market conditions
• the specific objectives of the investor

Therefore, while the Sterling ratio can provide valuable insights into an investment’s risk-adjusted performance, it should not be the sole determinant in investment decision-making. Other factors, such as the investment’s objectives, the investor’s risk tolerance, and market conditions, should also be considered.

Can a high Sterling Ratio guarantee investment success?

A high Sterling ratio can indicate favorable risk-adjusted returns, but it doesn’t guarantee investment success as it doesn’t account for all factors influencing investment outcomes. Furthermore, any performance ratio looks at the past, and the future is unknown.

While a high Sterling ratio signifies improved risk-adjusted performance, it does not guarantee investment success. The Sterling Ratio is just one performance measure, and it does not predict future performance.

Investment success depends on a variety of factors, including:

• Market conditions
• Investment strategies
• The individual investor’s financial goals
• Risk tolerance
• Correlation to other strategies you might have

Therefore, while a high Sterling Ratio can indicate an investment that has historically offered good returns for the level of risk taken, you must consider the above bullet points.

Summary

The Sterling Ratio is a powerful tool for helping investors assess their investments’ risk-adjusted performance. Focusing on average drawdowns rather than volatility provides an alternative perspective on risk that is particularly relevant in the hedge fund industry.

Its value lies in its ability to compare different investments and asset classes and its relevance to investors who are more concerned with managing downside risk and ensuring consistency of returns.

However, the ratio is just one of many tools available to investors. Its use should be complemented by other financial metrics and considerations, including the individual investor’s financial goals and risk tolerance, not to mention the correlation to your other strategies (you should have many strategies).

FAQ

What is the Sterling Ratio Investopedia?

The Sterling Ratio, as defined by Investopedia, is a measure used to evaluate the risk-adjusted returns of an investment strategy, particularly in the context of hedge funds.

What is the difference between Profit Factor and Sterling Ratio?

Profit Factor and Sterling Ratio are both financial metrics used to evaluate the performance of investment strategies, but they measure different aspects:

Profit Factor quantifies the ratio of total profit to total loss from a trading strategy.

Sterling Ratio, on the other hand, evaluates risk-adjusted returns by comparing an investment’s average annual return to its average drawdowns.

How do you calculate Sterling Ratio?

To calculate the Sterling Ratio, you divide the portfolio’s excess return over the risk-free rate by its downside deviation. However, alternative definitions and calculations exist.

What does a higher Sterling Ratio indicate?

A higher Sterling Ratio indicates superior risk-adjusted returns. An investment demonstrating a greater Sterling ratio suggests it has achieved a more favorable risk-to-reward balance than an investment without risk.