Sterling Ratio
The Sterling ratio is a risk-adjusted performance measure that divides the annualized return by the average maximum drawdown (typically measured over rolling annual periods) minus 10%, providing a return-per-unit-of-drawdown metric that emphasizes the manager's ability to preserve capital from peak to trough. It is commonly used by commodity trading advisors (CTAs) and trend-following fund managers where drawdown risk is a primary investor concern.
Key takeaways
- The Sterling ratio = Annualized Return / (Average Annual Maximum Drawdown - 10%), where the -10% adjustment was introduced by Deane Sterling Jones to prevent the denominator from being too small when drawdowns are minimal.
- The 10% adjustment is a somewhat arbitrary convention; some practitioners use the modified Sterling ratio without the adjustment, or use the worst annual drawdown rather than the average.
- Higher Sterling ratios indicate better return-per-unit-of-drawdown risk; ratios above 1.0 are generally considered good for trend-following strategies, while values above 2.0 indicate exceptional performance.
- The Sterling ratio complements the Sharpe ratio by focusing on the sequential (path-dependent) loss dimension rather than symmetrical return dispersion, making it more intuitive for investors concerned about peak-to-trough losses.
- The Calmar ratio is closely related: it divides annualized return by maximum drawdown without any adjustment, using the worst observed drawdown in the measurement period rather than an average.
Explanation
The Sterling ratio was developed by Deane Sterling Jones as a performance measure specifically suited to commodity trading advisors and trend-following managers, who frequently exhibit extended drawdown periods during trending-market reversals. The fundamental question asked by the Sterling ratio is: 'How much annual return did this manager generate relative to the average annual decline in their portfolio from peak to trough?' This is a more practically meaningful measure for many investors than the Sharpe ratio, which aggregates all volatility into a single number without regard to the sequential pattern of losses.
Drawdown — the decline in portfolio value from its most recent peak to its most recent trough — captures something fundamentally different from standard deviation. Two strategies with identical standard deviation can have very different drawdown profiles: a strategy with many small, rapidly recovering losses and few extended drawdowns will have a better drawdown profile than one with sustained multi-month losing periods that compound into large peak-to-trough declines. Investors who need to potentially liquidate holdings (endowments facing spending needs, pension funds with liability matching requirements) are particularly sensitive to the drawdown dimension of risk.
The construction of the Sterling ratio requires careful specification. The numerator is the annualized return over the measurement period — typically three to five years of monthly or daily data. The denominator is the average of the maximum drawdown in each calendar year over the measurement period, minus the 10% convention adjustment. For example, if a fund's maximum annual drawdowns over five years were 15%, 12%, 8%, 18%, and 10%, the average is 12.6%, and the adjusted denominator is 12.6% - 10% = 2.6% — producing a high Sterling ratio for a modest return. The 10% adjustment was intended to normalize for managers with very low drawdowns, preventing the denominator from approaching zero.
Comparisons across strategies using the Sterling ratio must account for the measurement period's significance. A ratio computed over a full market cycle (including both bull and bear periods) is more informative than one computed only during a prolonged bull market where drawdowns were minimal. Managers who pursue inherently low-drawdown strategies (market-neutral, short volatility in benign periods) may show high Sterling ratios in calm periods but catastrophic drawdowns during stress — the ratio would then look entirely different over the full cycle.
For CTA evaluation, the Sterling ratio is part of a standard performance analytics package alongside the Sharpe ratio, Calmar ratio, time underwater (percentage of time in drawdown), and maximum drawdown. Together, these measures provide a multi-dimensional view of risk-adjusted performance that is more informative than any single metric. Allocators typically construct performance attribution reports showing how these metrics change over different sub-periods and market regimes — separately evaluating performance in bull markets, bear markets, high-volatility, and low-volatility environments.
Formula
Sterling Ratio = Annualized Return / (Average Annual Maximum Drawdown - 10%)
Example
A trend-following CTA reports the following performance over five years. Annual returns: Year 1: +22%, Year 2: +8%, Year 3: -5%, Year 4: +30%, Year 5: +15%. Annual maximum drawdowns: Year 1: 8%, Year 2: 12%, Year 3: 22%, Year 4: 6%, Year 5: 9%. Geometric annual return: approximately 13.5%. Average maximum drawdown: (8+12+22+6+9)/5 = 11.4%. Sterling ratio = 13.5% / (11.4% - 10%) = 13.5% / 1.4% = 9.6 — an extremely high value reflecting low average drawdowns relative to return. However, the 22% drawdown in Year 3 might concern risk-sensitive investors. The Calmar ratio using worst drawdown: 13.5% / 22% = 0.61 — a more conservative measure. This example illustrates how the averaging convention in Sterling can produce very different numbers than the worst-case Calmar, and why using multiple drawdown-based metrics provides a more complete picture.
Related terms
Beta Coefficient Calmar Ratio Covariance Matrix Drawdown Efficient Market Hypothesis Ledoit Wolf Shrinkage Maximum Drawdown Sharpe Ratio Standard Deviation Transaction Costs In Portfolio Optimization Volatility