Drawdown is a crucial term for fund managers, and refers to the greatest percentage loss the fund has experienced, generally measured from the fund’s highest point to its lowest.

Q. We need to know this one because it’s one of the most basic things you need to know about a money manager… but, what is it, exactly?
A. It’s the maximum percentage loss that the manager or fund has experienced. By the way, it isn’t related to withdrawals from a fund, the % of money that’s been pulled out by investors… that’s a point of confusion sometimes because it also impacts the AUM. But drawdown is the maximum loss the fund has experienced.

Q. But…. Over what time?
A. Excellent question. Usually you mean “peak to valley”—the highest absolute point to the lowest, which can happen over a long period.

Q. And once you know the maximum drawdown, how do you put it in perspective in evaluating the manager?
A. Two big things. First, you want to know what was the length of the drawdown… that is, how long did it take to get back to the peak performance measure? Many hedge funds, for example, did very well in this regard during the crisis; they did lose money, but snapped back relatively quickly as compared to the S&P.

Q. That’s interesting. OK, length of drawdown is key. What else?
A. Well, lots of investors go the next step, by asking about the Calmar ratio. This compares the manager’s maximum drawdown to his average return over the last three years. Numerator is % return, denominator is the maximum loss: so, the higher the number is, the better. This gives you a pretty decent sense of how the relative risks and rewards of a given investment opportunity.

Q. So, add that to the list of Shapre, Sortino, and Standard Deviation as one of the important ways to measure fund performance.
A. Yes. But you don’t always have to be so fancy. Just understanding what a fund’s maximum drawdown was, and the length of that drawdown was, can tell you a lot.