What is a Drawdown?

A drawdown is a strategy that is used to determine the amount of financial risk that is associated with a given investment. The basic process involved with this strategy is to take into consideration the peaks and valleys of the investment’s movement within a given period of time. In most settings, tracking this movement is described as a peak-to-trough analysis, simply meaning that the assessment moves from the high point of the investment’s performance to its lowest point, and then follows its progress as the investment begins to recover. Generally, a drawdown is presented as a percentage rather than an actual dollar amount.

The use of the drawdown strategy can be employed with just about any type of investment opportunity, but is often employed with commodities. Various types of performance measures are used in the determination of this trend and the resulting percentage. Typically, the measures utilized are the Calmar ratio, the Sterling ratio, and the Burke ratio. Some may choose to use one of these measures, or run the calculation using each of the three in hopes of uncovering additional data that may be helpful in making decisions regarding the investment.

The Calmar ratio is helpful when assessing the degree of downside risk with a hedge fund, and takes into consideration the relationship between the compounded annual return and the drawdown. Typically, a three-year period is considered when employing this approach. The Sterling ratio is also useful with hedge funds and focuses on the relationship of the compounded annual return and the maximum drawdown, less ten percent. The Burke ratio takes a slightly different approach, in that it focuses on the amount of excess return associated with the investment, divided by the square root of the total of the largest squared drawdown.

The end result of calculating the drawdown is to determine the degree of risk associated with the investment. This makes it much easier to determine the potential for some amount of reduction in the equity associated with the investment within a given period of time, and use that data to project future movements. While the data collected and used to determine the drawdown is very helpful, investors will normally use this approach as one of several ways of evaluating the potential of an investment. As with most formulas for evaluating the potential of commodities or other securities, there is the need to allow for factors that were not relevant to past performance, but could exhibit some sort of effect in the future.