The Sterling ratio is the annualized return for the last 3 years divided by the average of the maximum drawdown in each of the preceding 3 years, plus an arbitrary 10 percent. Jones added the extra 10 percent to the drawdown as he believed that all maximum drawdowns would be exceeded in the future.
To calculate this average yearly drawdown, the latest 3 years (36 months) is divided into three separate 12-month periods and the maximum drawdown is calculated for each. Then these three drawdowns are averaged to produce the average yearly maximum drawdown for the 3-year period. If 3 years of data are not available, the available data is used.
Average drawdown = (D1 + D2 + D3) ÷ 3Where D1 = Maximum drawdown for first 12 months;
Sterling ratio = compound annualized ROR ÷ ABS (average drawdown − 10%)
Sterling ratio = average ROR (last 3 years) ÷ absolute (average drawdown − 10%)
D2 = Maximum drawdown for next 12 months;
D3 = Maximum drawdown for latest 12 months.
Much like other comparative, risk-adjusted statistics, the higher the Sterling ratio, the better. A high Sterling ratio means that the fund generates a higher return relative to its downside risk.