Sterling Ratio: Return Over Average Drawdown

Key Takeaways

• The sterling ratio divides compound return by the average annual maximum drawdown plus a 10 percent buffer.
• It uses average drawdown across years, not a single worst drawdown like the Calmar ratio.
• Investors often forget the original 10 percent adjustment, which inflates the score and breaks comparability.
• Higher values mean more reward per unit of typical losing-stretch pain, useful for ranking trend-following programs.

What It Is

The sterling ratio is a risk-adjusted return measure that pairs a strategy's compound return with the size of its drawdowns. A drawdown is the peak-to-trough drop in account value before a new high is reached, expressed as a percentage.

The classic version dates to around 1981 and was used in the managed futures industry. It defines return as the compound annualized rate over the last 3 years, and risk as the average of each year's maximum drawdown over that same window, with an extra 10 percent subtracted from the denominator.

The sterling ratio appears in several forms across vendors, so always check which definition a report uses before comparing two numbers.

The Intuition

Volatility-based measures like the Sharpe ratio treat every wobble as risk. For a trend follower that grinds sideways and then jumps, that overstates the danger. What actually hurts an investor is the depth of the losing stretch they have to sit through.

The sterling ratio answers a sharper question: for the pain of a typical bad year, how much return did I collect? Averaging drawdowns across several years smooths out one freak event and rewards strategies that keep their losing streaks shallow and consistent.

How the Sterling Ratio Works

The original formula expresses both pieces over a 3-year window:

Sterling Ratio = Compound Annual Return / (Average Annual Maximum Drawdown - 10%)

Where:

Average Annual Maximum Drawdown = mean of each year's largest peak-to-trough loss

The minus 10 percent is the part people drop. When the ratio was created, a risk-free Treasury yielded close to 10 percent, so the adjustment compared the strategy against a baseline a cash investor could earn for free. Many modern platforms omit it or make it a configurable buffer, which is why two "sterling ratios" can disagree.

A higher number is better. A reading above 1 means annual return exceeds the adjusted average drawdown.

Worked Example

A managed futures program reports a 20 percent compound annual return over 3 years. Its yearly maximum drawdowns were 10 percent, 14 percent, and 12 percent.

First, average the drawdowns:

Average Annual Maximum Drawdown = (10% + 14% + 12%) / 3 = 12%

Now apply the formula with the 10 percent adjustment:

Sterling Ratio = 20% / (12% + 10%) = 0.20 / 0.22 = 0.91

Note that some implementations write the denominator as drawdown plus 10 percent rather than minus, treating the 10 percent as a penalty buffer. If you instead drop the adjustment entirely, the same data gives 0.20 / 0.12 = 1.67. The number nearly doubles with no change in the strategy, which is exactly why the convention matters.

Common Mistakes

1. Ignoring the 10 percent adjustment. Leaving it out inflates the score and makes a program look better than the original definition intends. Always state whether your figure includes it.
2. Comparing across different lookback windows. A 3-year sterling ratio and a 5-year one are not the same metric. Drawdown averages shift with the period, so match the windows before ranking.
3. Confusing it with the Calmar ratio. Calmar uses a single maximum drawdown over the period. Sterling averages the worst drawdown from each year. They reward different return shapes.
4. Using it on too short a history. With only one year of data there is nothing to average, and the measure collapses toward Calmar. It needs several years to mean anything.
5. Treating it as cross-asset comparable. A bond fund and a commodity trend follower have wildly different natural drawdowns. The ratio is best for ranking similar strategies, not for declaring one asset class superior.

Frequently Asked Questions

What is the sterling ratio in simple terms? The sterling ratio shows how much annual return a strategy earned for each unit of its average yearly drawdown. A higher number means more reward for the typical losing stretch you had to endure.

How does the sterling ratio affect investment decisions? It helps you rank managers or strategies that have similar styles, such as trend-following futures programs. A program with a higher sterling ratio delivered more return per unit of average drawdown, which can guide allocation between otherwise comparable options.

What is a real-world example of the sterling ratio? A futures program earning 20 percent a year with a 12 percent average drawdown scores 0.91 using the original formula with the 10 percent buffer. Drop the buffer and the same program scores 1.67, showing how sensitive the metric is to convention.

How can investors use the sterling ratio effectively? Always confirm the exact definition, the lookback window, and whether the 10 percent adjustment is applied. Then compare only strategies that share a style and time period, never across unrelated asset classes.

How is the sterling ratio different from the Calmar ratio? Both divide return by drawdown, but the Calmar ratio uses one maximum drawdown over the whole period. The sterling ratio averages the worst drawdown from each year, so it reflects recurring pain rather than a single worst event.

Sources

1. Wall Street Mojo. "Sterling Ratio." https://www.wallstreetmojo.com/sterling-ratio/
2. RCM Alternatives. "The Sterling Ratio Explained." https://www.rcmalternatives.com/2014/03/the-sterling-ratio-explained/
3. FXCM. "Sterling Ratio." https://www.fxcm.com/markets/insights/sterling-ratio/
4. Fundpeak. "Sterling Ratio." https://www.fundpeak.com/factsheet-production-help/sterling-ratio/

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.