Sitting here five years from the March 2009 lows in the stock market, it can be easy to forget just what makes alternative investments appealing for many investors. It isn’t the top line performance such as we’ve seen in stocks recently, more often than not it’s the risk adjusted performance.

The most popular (and overused) risk adjusted performance metric is the Sharpe Ratio, but the investment world is littered with many more of these tools for comparing different investments and asset classes to one another on how much return they earn *per unit of risk. *The risk part is what changes in these metrics, with the Sharpe seeing risk as volatility, the Sortino as downside volatility, or the MAR by maximum drawdown.

Enter the Sterling Ratio, which measures return over *average* drawdown, versus the more commonly used max drawdown – which is the largest peak to valley loss experienced over the entire track record. While the Max Drawdown looks back over the entire period you’re analyzing and takes the worst point along that equity curve, a quick change of the look back allows one to see what the worst peak to valley loss was for each calendar year as well. From there, we can average the drawdowns of each year to come up with an Average Annual Drawdown.

Sterling Ratio = (Compound ROR) / ABS(Avg. Ann DD – 10%)

Some versions of the Sterling may also subtract the risk free rate (although it has been effectively 0% for the past 5 years, making it a moot point); giving investors a ratio of the average annual return over the average annual drawdown (less that 10%). Ideally that number would be greater than 1, so you are getting more reward for the risk taken each year, and the higher the better.

Now what the heck is that arbitrary -10% in there for? It’s sometimes listed as a positive number, too? Let’s first say, the result of the equation should be a positive number, so if you are putting in your drawdown as a negative number, then subtract the 10%, and then multiply the whole thing by a negative to result in a positive ratio. If putting the drawdown in as a positive number, then add 10% and your result is the same positive ratio.

There’s not much documentation on why the 10% is in there, or even what the original definition of the Sterling Ratio is – but our take is that the average drawdown over a typical 5 year period can be quite small (just look at stocks the past 5 years), and therefore a sort of ‘reality adjustment’ is needed. Another possibility may be that the ratio would break (divide by zero error) if there were no drawdowns over the period, so the formula included the arbitrary number to insure there was always something in the denominator.

A better ratio would have a ‘reality adjustment’ factor tied to the program’s volatility or some other sort of metric based on the program’s data instead of just picking 10% out of thin air. Imagine program’s which target drawdowns of less than 10% don’t like that number much, as it increases the risk denominator for them 150% or more, while a -30% drawdown program is only looking at a 33% increase.

So there you have it, another risk adjusted performance metric for your toolbox, although given the vagaries of that 10% and ability of programs to mask their true risk profile over short periods of time, we prefer to look at the MAR and the all time max drawdown instead of the average.

For more on those equations, here’s a list of posts on the other ratios:

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