Drawdown analysis can be an excellent way to screen investments. A Maximum Drawdown is the maximum amount of loss from an equity high through the drawdown and back to the point the equity high is reached again. There could be many drawdowns over a given date range and will be listed starting with the maximum drawdown. Figure 16 illustrates the maximum drawdown over the period 12-2009 to 07-2011, although it is not the only drawdown. Maximum drawdowns being analyzed on numerous investments should be calculated over the same date range.
In addition, it is important to remember that drawdowns are relative to return. The S&P 500 Index in Figure 17 exhibits drawdowns that would give most investors pause. However, if you chart the losses and time underwater versus the returns of the fund (Figure 18), some investors might find the fund worthy of additional consideration.
There are numerous reasons for a drawdown, including market stress, giving back part of unrealized profits after a large increase in equity, or just poor trading. From a quantitative perspective, however, it is important to analyze the reasons that caused a particular drawdown, and not exclude a fund based on just absolute numbers.
Investors who are required to select and monitor investment managers should develop a basic understanding of investment statistics. Quantitative tools can provide you with good insight that you can use in your qualitative interviews with managers and when monitoring your investments.