Most volatility measures used in fund analysis suffer from one anomaly - they measure upward volatility the same way they do for downward volatility - while for investors, its downward volatility that worries them, not upward volatility. Bottom line that investors want to know is this: when markets fall, how badly does this fund fall? The hot new tool that's becoming widely accepted to answer exactly this question is drawdown analysis.

According to Investopedia, a drawdown is the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Those tracking the entity measure from the time a retrenchment begins to when it reaches a new high. This drawdown method of recording is useful because a valley can't be measured until a new high occurs. Once the investment, fund or commodity reaches a new high, the tracker records the percentage change from the old high to the smallest trough. Drawdowns help determine an investment's financial risk. Both the Calmar and Sterling ratios use this metric to compare a security's possible reward to its risk. Drawdown is simply the negative half of standard deviation in relation to a stock's share price. A drawdown from a share price's high to its low is considered its drawdown amount.

Maximum drawdown measures the most extreme values hit by the fund in the given time period. According to asset management firm Robeco, "Maximum drawdown is defined as the peak-to-trough decline of an investment during a specific period and is usually quoted as a percentage of the peak value." It measures a portfolio's biggest loss over the investor's time horizon.

Examples

The concept of drawdown measures the functioning of the fund from the just attained highs to the lows. For example,let us assume one has invested Rs.1.00 crores in a portfolio. Suppose the fund soars 60%in a given time period. That would make the fund worth Rs.1.60 crores.At that point, there is a correction and the fund falls to Rs.1.20 crores. In normal conventional terms this would reflect a 20% return, indeed quite a good performance. But, seen through the prism of the drawdown metric, which is calculated as the difference between the highest achieved high, namely Rs.1.60 crores, and Rs.1.20 crores the bottom reached by the fund, there is a big fall in performance. This means that when Rs. 40 lakhs isdivided by Rs. 1.2 crores there is a big drop of 33.33% in value.

Maximum drawdown can be understood as follows. Let us assume that a portfolio begins with a value of Rs. 50 lakhs. Let us further assume that the portfolio grows over a period to Rs.75 lakhs. At which point in time it collapses to Rs. 40 lakhs, before recovering to Rs. 60 lakhs. Then again, in a severe bear market, it drops to Rs. 35 lakhs and on recovery, soars to Rs. 80 lakhs. The maximum drawdown is calculated as the difference between Rs. 35 lakhs and Rs. 75 lakhs(-53.33%). The point to note is that it is the first peak, before the fall that is taken for calculation purposes. The intermediate peak of Rs. 60 lakhs and the ultimate peak of Rs. 80 lakhs are not considered for calculations. On the other hand the trough is taken to be the lowest ever it reaches, that is Rs. 35 lakhs and not the first low of Rs. 40 lakhs.

Why this metric is so important

The concept of drawdown is vital because it points directly, bluntly and clearly to the weaknesses in the management of a fund. Maximum drawdown takes the concept even further. Other metrics like standard deviation may average out poor performance. Standard deviation treats downside deviation, which is harmful, the same as upside deviation which is really fine, just the same.

Since maximum drawdown measures the extreme values on the roller-coaster ride of a fund, it shows investors how far their investments can fall. This worst case scenario certainly helps in managing the risks involved wisely.

Maximum drawdown (MDD) should be used with due care. It is essential to properly define the time horizon that is being considered. 'MDD should be used in the right perspective to derive the maximum benefit from it. In this regard, particular attention should be paid to the time period being considered. For instance, a hypothetical long-only U.S. fund Gamma has been in existence since 2000, and had a maximum drawdown of -30% in the period ending 2010. While this may seem like a huge loss, note that the S&P 500 had plunged more than 55% from its peak in October 2007 to its trough in March 2009. While other metrics would need to be considered to assess Gamma fund's overall performance, from the viewpoint of MDD, it has outperformed its benchmark by a huge margin' (Investopedia).

Using the metric

Usually maximum drawdown is expressed as a percentage of the peak value. Thus this can be measured based on absolute returns to delineate strategies that can be used during market downturns; like low volatility strategies. Maximum drawdown can also be calculated in relation to a particular benchmark. This can be used to develop strategies that reveal steady performance over a period.

According to Robeco; 'For example, two strategies can have the same average outperformance, tracking error, information ratio and volatility, but their maximum drawdowns compared to the benchmark can be very different.'

'For instance, suppose that the first one achieves a monthly performance of 1%, -0.5%, 1%, -0.5% and so on versus the benchmark, while the second strategy achieve an outperformance of 1% each month during the first half of the sample, but an underperformance of 0.5% each month during the second half of the sample. Most investors would strongly prefer the first strategy, because it has a much lower maximum drawdown than the second strategy! Furthermore, the length of the drawdown period is shorter. We use maximum drawdown as one of the key statistics for evaluating our quantitative investment strategies and for deciding on the introduction of new variables in our models'.

Mitigating risk

The drawdown metric can be a very useful tool for managing portfolio risk. As fund valuessurge, investors can mark out value levels which would act as warning signs. When stock values sag, investors can take protective actions at the various value levels already identified, thus saving their investments. Another advantage is that using drawdown can improve one's performance as against other funds and fund managers. Simply put, theprudent manager who uses the drawdown metric would have the advantage of having taken adequate steps to protect his investments,especially when markets begin to turn weak. Investors expect not only a healthy performance but also the least unhappy experiences during market downturns. Fund managers who shape their strategies to do well on both expectations, will be the winners of the future.

Share this article