The Sterling Ratio is a risk-adjusted measure of return on an investment that focuses on downside volatility.
Calculation: (CAGR - Risk-free Rate) / Average of the Largest Annual Losses.
Advantages: Emphasizes potential for loss, focuses on larger losses, and provides a realistic view of performance by considering a risk-free rate.
Disadvantages: Heavily relies on historical data and might overemphasize the impact of outliers.
In practice: the 'Fund A' example with a 10-year CAGR of 15%, risk-free rate of 6%, and five worst drawdowns resulted in a Sterling Ratio of 0.90, indicating a good risk-reward trade-off.
Empirical evidence from India suggests that funds with higher Sterling Ratios tend to perform better during downturns.
Important note: Investment decisions should not be solely based on the Sterling Ratio, consider other factors and metrics.