Creating a Drawdown Plan

The standard definition of a drawdown is the decline in the value of a portfolio from peak to trough, which is measured in percentage terms.  By using this definition a drawdown can only be calculated once a portfolio begins to recover after the trough is in place.  Some investment managers use specific time horizons to measure drawdowns which have happened over quarterly periods or even annual periods.

A quarterly or 90-day drawn measures the value of a portfolio at the beginning of every three month period and compares that to the value 90-day later.  This type of analysis is a rolling analysis where periods could start every day during the life of the fund or at the beginning of every month. In this situation an investment manager is looking for the worst drawdown during this rolling period which would be call a maximum drawdown.  Some manager will even consider a maximum drawdown over a specific period since inception.

The maximum draw down encapsulates what is considered tail risk which is the risk associated with an event that is unlikely to occur.  A hedge fund that boasts smooth gains of 1% per month over a 5-year period that has a maximum drawdown of 20% should produce a red flag.  On the other hand, a fund that is generally volatile and produces a large maximum drawdown only reflects the tail risk of this volatility.

The maximum drawdown is not a perfect measure of risk as it is time dependent. Drawdown frequency, as well as the size of the drawdown also needs to be considered. Additionally, a maximum drawdown is a backward looking event, but it can give you an idea of the manager’s appetite for risk.

Creating a Drawdown Plan

Drawdowns are part of portfolio management.  Investors are paid to assume risk which means there will be times when trades produce losses.  The key obviously is to mitigate losses and live to trade another day.  With this in mind, and investor should think about the possible outcomes from a drawdown and how they should handle trading positions and risk management.

One of the first items to think about is the maximum loss on a returns basis that you are willing to accept before the strategy is halted and trading is terminated.    This percent should be based on how much you are looking to earn, and design a risk management strategy based on this process.

An investor should consider managing a drawdown on an annualized basis as well as a monthly basis.  On a monthly basis, the drawdown maximum can be flexible but should be aligned with the targeted reward.  With a strategy that is geared toward making 20%, the monthly gains will average 1.66%.  In the same way a manager will attempt to keep losses below 20% on an annualized basis, the monthly losses should be geared toward avoiding losses that are more than 1.66%.

Once portfolio loses more than the planned monthly amount, what should a manager do?  There are a number of techniques which include winding down the portfolio, hedging the portfolio or unwinding the riskier portions of a portfolio.

Understanding a drawdown that is periodic or based on a peak to trough decline is an important concept toward generating consistent returns.  All investment strategies that look for perform above the risk free rate of return will incorporate risk into a portfolio.  The more risk that is assume the greater the reward expected.