Sterling Ratio

The Sterling Ratio is defined as a metric used to examine an investment portfolio's risk-adjusted returns. The higher the ratio, the better, as it shows that the investment yields a higher return than the predicted level of risk. It calculates a return above the average drawdown. 

The ratio serves as a vital metric for assessing the risk-to-reward profile of a portfolio or trading approach. It evaluates investment returns relative to the risk taken, focusing on drawdowns rather than mere volatility. It aids in prudent risk management within investments through the comparison of returns on investment against the average of peak drawdowns.

• The sterling ratio measures risk-adjusted returns by considering draws on risk.
• To calculate this ratio for a hedge fund, divide its annualized return over the past three years by the mean of the maximum drawdowns in each year. The resulting mean drawdown is then reduced by 10% to provide a more realistic scaling of the ratio.
• The ratio is used for portfolio comparison, asset allocation optimization, manager appraisal, and behavioral analysis. 
• Its disadvantages include assuming equal psychological impact of drawdowns and overlooking human psychology's tendency to magnify losses. 

The Sterling ratio is a risk-adjusted measure of return that incorporates the maximum drawdown as a risk indicator. Drawdown risk consideration is what makes the ratio vital in portfolio analysis. However, its application is limited to situations where drawdown figures can be adequately accommodated within the ratio. Another significant drawback of the ratio arises from its reliance on the three-year interval. Due to this, one cannot capture positive returns or substantial drawdowns occurring just before this period. If the preceding three years lack any drawdowns, the ratio thus becomes ineffective.

Certain variations of the Sterling Ratio may incorporate the subtraction of the risk-free rate. This adjustment provides investors with a ratio comparing the average annual return of the portfolio to the average annual drawdown (a reduction of 10%). Ideally, this ratio should exceed 1, indicating a higher reward relative to the risk taken each year, with higher values being more favorable.

Interestingly, the arbitrary -10% adjustment may also be a positive number in some cases. If the drawdown input is a negative number, to ensure a positive result for the equation, subtracting 10% and multiplying the entire expression by -1 would yield a positive ratio. Alternatively, if the drawdown entry is a positive number, adding 10% would produce the same positive ratio. The confusion exists as the information explaining the specific rationale behind the inclusion of the 10% adjustment is scarce, and there is no documentation of the original definition of the Sterling Ratio.

One can compute the Sterling ratio by dividing the compound annualized return over the previous three years by the average yearly maximum drawdown over the same period with a 10% deduction. The 36-month returns are divided into three 12-month periods to find the average yearly drawdown, and the maximum drawdown is calculated for each. One can average these three drawdowns to determine the average yearly maximum drawdown for the three-year duration, utilizing available data if there are fewer than three years' worth. A higher Sterling ratio indicates superior performance, reflecting a greater return relative to the risk incurred, akin to other risk-adjusted metrics.

One can represent it using the formula:

Sterling Ratio formula = periodic portfolio return / (Average Annual maximum Drawdown – 10%)

Let us look into a few examples to understand the concept better:

Example #1

Let us consider a hypothetical example involving Dan, an investor who wants to calculate the Sterling ratio for his portfolio enhancement. In this scenario, Dan has tracked the performance of his portfolio over the past three years and has gathered the necessary data.

Dan's compounded periodic portfolio return over the three years is 20%. He also calculates the average annual maximum drawdown to be 12%. Applying the formula for the Sterling ratio:

Sterling Ratio formula = Periodic Portfolio Return / (Average Annual maximum Drawdown – 10%)

Sterling ratio = (0.20 / (0.12 - 0.10) = (0.20 / 0.02) = 10

Dan's calculated Sterling ratio for his portfolio enhancement is 10. The ratio is greater than 1, indicating that Dan's portfolio generates more rewards for the risk taken each year, which is favorable.

Example #2

The paper titled Examining Sharp, Sortino and Sterling Ratios in Portfolio Management, Evidence from the Tehran Stock Exchange, authored by Pegah Kolbadi and Hamed Ahmadinia (Corresponding author), infers that the evaluation of investment companies' performance using the Sharpe, Sortino, and Sterling ratios yielded different results. This discrepancy can be attributed to the different theories they are based on and their treatment of downside and upside risk.

The post-modern portfolio theory, which employs the Sterling and Sortino ratios, acknowledges the difference between these two types of risks (upside and downside). The weak performance of the Sharpe ratio in comparison to the Sortino and Sterling ratios, particularly when evaluating investment companies, suggests that ratios associated with the post-modern portfolio theory provide a better definition of performance. 

Furthermore, the ranking outcomes based on the Sterling and Sortino ratios also outperformed those of the Sharpe ratio. This raises questions about the historical results of standard deviation, which the Sharpe ratio relies on when compared to ratios utilizing alternative distributions and considering lower volatility. It is important to note that the research was conducted during a financial crisis, which could have negatively affected the performance of the companies. Overall, the study suggests that the Sterling ratio, along with the Sortino ratio, offers valuable insights when assessing the performance of investment companies, particularly in the context of downside and upside risk.

Some of the advantages and disadvantages of sterling ratio are given as follows:

#1 - Advantages

• It aids in determining the optimal risk-reward ratio and evaluating fund managers' abilities to handle downside risk.
• The metric allows for optimizing asset allocation. 
• It helps in understanding investor emotions during drawdowns, allows for improved decision-making, and avoids panic selling.

#2 - Disadvantages 

• The Sterling Ratio works on the assumption that drawdowns exhibit symmetry, meaning losses carry an equal psychological impact as gains. However, human psychology tends to magnify the impact of losses, which this ratio fails to consider fully.
• It overlooks tail risk, such as extreme events and deviations from normal return distributions.
• Historical data might not provide precise forecasts for future drawdowns.

The differences between both the concepts are given as follows:

• The Sharpe ratio quantifies risk-adjusted return using the factor of volatility as the measure of risk. The Sterling ratio assesses risk-adjusted return based on the factor of drawdowns (downside deviation) as the risk metric.
• The Sharpe ratio determines risk-adjusted returns by dividing the difference between the risk-free rate and the investment return by the standard deviation of the investment returns. The Sterling ratio assesses risk by calculating the average yearly drawdown rather than the standard deviation.
• The Sharpe ratio highlights the variability factor of the returns. The Sterling ratio emphasizes the average loss from the highest to the lowest position within a single year.

This has been a guide to what is Sterling Ratio. Here, we explain its examples, comparison with the Sharpe ratio, how to calculate it, & advantages. You may also have a look at the following articles -

• Omega Ratio
• Calmar Ratio
• Treynor Ratio