Maximum Drawdown

Average returns and standard deviation describe how a fund usually behaves. Investors also want to know the worst it has done: if they had come in at the top, how much would they have lost before things turned?

Maximum drawdown (MDD) answers exactly that. The workbook defines it as "the peak-to-trough decline in the Assets under Management (AUM) of a Category III AIF, during a specific reporting period", usually quoted as a percentage of the peak — the highest AUM achieved by the fund in that period.

It measures "the extent of the greatest loss in a portfolio, until a new peak value is created". An investor would ideally like to see zero. In practice the number only means something when it is read against the time period chosen and against what the benchmark did over the same period.

Computing it.

1. Find the peak value — the highest AUM in the reporting period.
2. Find the trough value — the lowest AUM reached after that peak, before a new peak.
3. Divide the fall by the peak.

The workbook's Example 13 (quarter ending 31 March 2020):

The workbook's conclusion: although -13.71% is high, it is much lower than the benchmark's -38.78%, so even when markets faced downside risk from external factors, the fund's downside risk was lower than the market's.

What it does not tell you. The workbook names two limitations: MDD does not take into consideration how often the portfolio experiences large losses, and it does not indicate the length of time an investor would need to recover the loss.

Where it sits. MDD is one of the risk-adjusted return and performance measures in Chapter 6, alongside the Sharpe ratio, the Treynor ratio and Value at Risk.

MDD = (Trough Value - Peak Value) / Peak Value

Peak   = highest AUM in the reporting period
Trough = lowest AUM after that peak, before a new peak

Illustrative figures. Brahmaputra Long-Short Fund, a Category III AIF, reports month-end AUM for the half-year:

Fund MDD      = (402 - 480) / 480          = -16.25%
Benchmark MDD = (17,600 - 22,000) / 22,000 = -20.00%

The fund's worst fall was smaller than its benchmark's, which supports the manager's claim that the short book cushioned the decline.

Now Mrs Rao, who invested at the May peak, asks when she will be back to Rs 480 crore of fund value. MDD cannot answer that: it tells her how deep the hole was, not how long the climb out will take — the second limitation the workbook names. Nor does it say whether a 16% fall happens to this fund once a decade or twice a year.

Chapter 6 (Fees Structure, Fund Performance and Benchmarking) covers maximum drawdown at 6.2.5.3 with the Fund PQR and NIFTY50 example, between the Treynor ratio and Value at Risk. Expect a computation question from peak and trough values, an interpretation question comparing the fund with its benchmark, and a question on the measure's limitations.

• Trough minus peak, divided by peak — the result is negative. Dividing by the trough is the common slip.
• The trough must come after the peak. A low point before the high point is not a drawdown from that high.
• Read it against the benchmark and the period. -13.71% looked bad in isolation but was far better than the market's -38.78%.
• MDD ignores frequency and recovery time. It says nothing about how often large losses occur or how long recovery takes.
• It is quoted on AUM in the workbook's definition, not on a single stock's price.
• Do not confuse it with Value at Risk, which is a probability-based estimate of maximum expected loss at a confidence level.