Investing in drawdowns, good idea?

Even the best investor isn't right all the time, and consequently loses at times. These
losses result in drawdowns. A drawdown is defined as the peak-to-valley decline during a
specific record period of an investment, fund or commodity. A drawdown is usually quoted
as the percentage between the peak and the valley. Another property of drawdowns is
that it can generally not be predicted when they occur, nor what percentage of losses will
have to be born before an investment strategy again becomes profitable. Therefore
historic drawdowns are usually evaluated to get a sense of the risk-reward ratio of a
particular investment strategy.

The maximum drawdown over a certain period of time is often seen as a kind of worst
case scenario in a profitable investment strategy. It is often believed to be advantageous
to invest in a hedge fund when it is in a drawdown, the underlying idea being “what goes
down must come up”. Is this believe justified? To answer this question we will examine a
fictitious hedge fund, the ACME Quant fund”. The ACME Quant fund applies a successful
day trading strategy that has a normal random distribution of profits and losses. On
average this hedge fund wins 0.1% a day with a standard deviation of 0.75%. Therefore
approximately 56% of all trades are profitable. This results in an average annual
compounded return of approximately 28%, and a profit factor of about 1.5. The figure
below shows the intrinsic value of the ACME Quant fund over five years (1250 trades).

Figure 1: Intrinsic value of the ACME Quant fund.

From figure 1 it is clear that the ACME Quant fund had a number of drawdowns. These
drawdowns are shown in figure 2.

Research Note: Investing in drawdowns, good idea?

2 Figure 2: Drawdowns of the ACME Quant fund.

The maximum drawdown over the examined period is roughly 8%. The question is can
you expect a higher return if you invest the next time the ACME Quant fund is in a
drawdown of the order of 8%? The correct answer in this case is absolutely not. Why? The
answer is simple, the distribution of profits and losses is random. This implies that the
expected return for each trade is 0.1% regardless of whether the fund is in a drawdown or
not. This also implies that the probability for a drawdown of for example 8% is the same
at any point in time. So if the fund is in a drawdown of 8% the probability of having the
intrinsic value dropping another 8% leading to a 15.4% drawdown is exactly the same as
having the intrinsic value dropping 8% from a high water mark. Interestingly enough, this
argument also shows that a drawdown is not necessarily a measure for a worse case
scenario, as the maximum drawdown will generally increase over time. Although a
drawdown of 15% is pretty unlikely over a period of five years, it is far more likely to
occur over a period of for example fifty years. Is it therefore bad to invest in such a fund
when the fund is in a drawdown? No, it is simply no better or worse than investing at any
other time.

Of course this arguments hinges on the assumption that the distribution of profits and
losses is random. But although there may be numerous mutual funds that do not have a
random distribution of profits and losses, many hedge funds will show an distribution that
is approximately random. In any case this argument at least shows that it is not
necessarily more profitable to invest in drawdowns.

Menno Dreischor
Managing Partner MTR Invest

Research Note: Investing in drawdowns, good idea?