As you read this week’s newsletter, we may sound like a broken record, but when it comes to investing managed futures, understanding risk is the single most important component of success, in our opinion. The cornerstone of risk analysis, for many investors, is the dreaded drawdown. A drawdown is the “pain” experienced by an investor in a specific investment. As an example, an investor starting out with a $100,000 account who sees it fall down to $80,000 before it runs back up to $110,000 saw a $20,000 loss ($100K – $80K), which would equal a -20% ($20K/$100K) drawdown. The so called Maximum Drawdown (Max DD) is the worst such peak to valley down period for an investment.
The standard across the managed futures industry when talking about Max Drawdown is to show Max DD as the worst peak to valley loss on an END-of month-basis. This presentation of data is derived from the NFA rules on creation of disclosure documents which states all performance calculations must be done on a monthly basis.
But the story takes an unexpected turn if the max drawdown number is calculated using daily data instead of month end data. When considering the worst intra-month performance (using daily data) instead of the numbers CTAs put on the books at the end of the month, a very different picture can emerge.
Consider the example below of a fictitious investment which starts at $100,000 and meanders back and forth for a few months before settling out at around $130,000. Now, the whole point of looking at the drawdown in the first place is to know that the investment didn’t just go from $100k to $130k in a straight shot upwards. There were many bends and turns lower in the process.
But when using the standard end of month drawdown measure, the green line, we end up ignoring many of those same bends and turns we were intent on seeing with the max drawdown number. Consider that in the standard end of month drawdown measure (in green in the graph below), the fictitious investment had an end of month Max DD of around $45,000 (from $225,000 down to around $180,000), or -20%. Now, it is plain that there were higher highs and lower lows on the blue line (the daily ups and downs), and when running the numbers on this we can tell you that the fictitious investment went from around $245,000 down to $150,000 for a max Drawdown on a daily basis of -$75,000 or -30%.
The following is a mere example and not representative of trading in actual accounts:
Now, it’s easy to say that “all’s well that ends well,” but is that really the case? This is just a fictitious example, but the intramonth DD here was 1.5 times what you would see on the end of month basis. That’s a pretty big difference, especially when considering many investors use 1.5 times the past max DD level as a rule of thumb for assessing when a CTA has become riskier than the investor signed up for.
With all this in mind, to what extent should intra-month drawdowns guide investor portfolio decisions? In our high-speed, hyper-connect world, where clients can see their balances in real time during the day and review statements sent to them every night, these intra-month drawdowns are just as visible, and, especially as we repeatedly drill into their heads that past performance is not necessarily indicative of future results, can be even more unnerving.