A drawdown disguised as a pick-me-up?

Drawdown, as a word, has a negative ring to it – sucked under, pulled below the surface, yanked downward by factors beyond control… you get the idea.

In the hedge fund world, drawdowns are a simple fact of life – a way of measuring the decline of the value of an investment from its historical peak. Before the 2008 financial massacre and ensuing economic crunch, drawdowns were considered as one way to measure a fund and manager’s performance. That is, if the fund experienced a significant drawdown, it was likely for a particular reason.

Following 2008 and 2009, when the vast majority of hedge funds got hit with drawdowns, that kind of evaluation metric went out the window. However, with the steady performance recovery in 2010 and continued good times anticipated for 2011, delving more deeply into drawdowns and what they mean has come back in vogue.

A recent academic report by Sevinc Cukurova and Jose M. Marin (click here to download from SSRN) is case and point that interpreting what drawdowns mean are back in style. Their paper, entitled On the Economics of Hedge Fund Drawdown Status: Performance, Insurance Selling and Darwinian Selection, focuses on what kind of risk proxy large drawdowns provide.

But, contrary to what most people expect to hear when they hear of drawdowns, i.e. a connotation of negative performance, what Cukurova and Marin conclude in their research is that drawdowns, especially larger ones, are actually predictive of outstanding performance.

By definition, a drawdown is measured from the time a retrenchment begins to when a new high is reached. This method is used because a valley can’t be measured until a new high occurs. Once the new high is reached, the percentage change from the old high to the smallest trough is recorded.

What Cukurova and Marin attempt to do in their report is examine various funds’ drawdowns relative to the drawdowns of other funds in the market rather than in isolation, and analyze the dynamics of hedge funds’ drawdowns instead of their maximum past level – a different approach than looking at drawdowns specifically from a historical returns and impact standpoint.

Now old-school thought presumes that a hedge fund manager doesn’t want to experience any kind of drawdown for obvious reasons: It ruins their chances of making money that is tied to the stickiness of their underlying assets.

As Cukurova and Marin note,  talented managers in principle – and especially those implementing a sound risk management technology – will tend to exhibit small drawdowns. Outstanding performance should therefore be associated with hedge funds that persistently exhibit a low drawdown status.

What the duo argue, however, thanks to the “contaminating” presence of funds that merely mimic low-drawdown funds – funds run by low-talent traders who specialize in strategies akin to selling insurance – that by their very nature usually place the fund in the lowest drawdown decile. (See two charts below showing performance based on low drawdowns and high drawdowns.)

“These strategies resemble a dynamic strategy of rolling over short positions in deep out-of-the-money put options on some broad stock or commodity index,” the authors note. “All of them share the property of delivering positive returns in normal times but have the (hidden) cost of large losses in times of turmoil. They differ from the strategies of talented investors in that they are not associated with outstanding performance once proper account is taken of the true risks involved.”

Harsh stuff!

Furthermore, the authors point to a “Darwinian” selection process within the hedge fund industry: funds that “survive” in the largest drawdown decile for several periods are actually managed by talented managers exhibiting outstanding performance, counter to mainstream expectations that a few drawdowns would pull them down the proverbial toilet.

Drawdown-affected managers: 1 — Smooth-flow managers: 0.

In short, the paper overwhelmingly concludes that portfolios of funds experiencing the largest drawdowns have the most outstanding performance, and that they get even better returns if they’ve experienced several big runs on the bank. It also concludes something that in practice both makes sense and rings true: risk conditional on survival is tantamount to outstanding performance.

So the next time an investor gives you the once-over because you’ve posted a drawdown or two, take heart in knowing that, according to academic research, you’re best performance is likely ahead of you.

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