Drawdown is a strategy to assess the financial risk of an investment by tracking its peaks and valleys over time. It is often used with commodities and calculated using performance metrics such as the Calmar, Sterling, and Burke ratios. The goal is to determine the degree of risk associated with the investment and project future movement.
A drawdown is a strategy that is used to determine the extent of financial risk associated with a particular investment. The basic process involved in this strategy is to take into account the peaks and valleys of investment movement within a given time frame. In most settings, tracking this movement is described as a peak-to-trough analysis, which simply means that the valuation moves from the highest point of the investment’s performance to the lowest point and then tracks its progress. when the investment starts to recover. Typically, a drawdown is presented as a percentage rather than an actual dollar amount.
The use of the drawdown strategy can be employed with any type of investment opportunity but is often employed with commodities. Various types of performance metrics are used to determine this trend and the resulting percentage. Typically, the measures used are the Calmar ratio, Sterling ratio, and Burke ratio. Some may choose to use one of these measures or perform the calculation using each of the three in hopes of discovering additional data that could be helpful in making investment decisions.
The Calmar ratio is helpful when assessing the degree of downside risk with a hedge fund and takes into consideration the relationship between compound annual return and drawdown. Typically, a three-year period is considered when using this approach. The sterling ratio is also useful with hedge funds and focuses on the ratio of compound annual return to maximum withdrawal, less than ten percent. The Burke report takes a slightly different approach, as 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 the drawdown calculation is to determine the degree of risk associated with the investment. This makes it much easier to determine the potential for a certain reduction in the equity associated with the investment within a given time period and to use that data to project future movement. While the data collected and used to determine drawdown is very useful, investors will typically use this approach as one of several ways to evaluate the potential of an investment. As with most formulas for evaluating the potential of commodities or other securities, factors that were not relevant to past performance, but which may have some sort of effect in the future, must be taken into account.
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