In the fields of risk management and trading strategy development drawdown is an important metric. It's an intuitive conclusion that investors seek strategies that exhibit low drawdowns. However, those who build trading strategies know that approachs which have the lowest drawdowns (or almost none) have a way of blowing up when the times get tough. There are several examples of a "picking up nickels in front of a steam roller" strategy.
Therefore an investor's track record with no drawdowns should be considered with suspicion. AllAboutAlpha.com has profiled a recent study that backs up this intuition. The study can be accessed directly here.
The title of the paper is On the Economics of Hedge Fund Drawdown Status: Performance, Insurance Selling and Darwinian Selection by Jose M. Marin and Sevinc Cukurova.
Abstract: In this paper we study the drawdown status of hedge funds as a hedge fund characteristic related to performance. A hedge fund's drawdown status is the decile to which the fund belongs in the industry's drawdown distribution (at a given point in time). Economic reasoning suggests that both the current level and the past evolution of a fund's drawdown status are informative of key fund aspects, including the manager's talent, as well as fund investors' assessment of the fund, and, hence, are predictive of future performance. The analysis delivers four completely new insights on hedge funds. First, the presence of insurance selling (shorting deep out-of-the-money puts) in the industry is large enough to make portfolios of low drawdown funds weak performers, in general, and bad performers in times of turmoil. Second, the market operates a Darwinian selection process according to which funds running large drawdowns for a prolonged period of time (survivers) are managed by truly talented traders who deliver outstanding future performance. Third, a completely new dimension of risk arises as a distinctive feature of hedge funds: risk conditional on survival is tantamount to outstanding performance. Fourth, drawdown status analysis raises serious concerns about the role played by other hedge fund characteristics -such as total delta- on fund performance and casts doubts on the validity of some performance evaluation measures -such as the Calmar and Sterling ratios- that are widely used in practice.
This is the personal blog of Emory Redd.
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