Saturday, September 14, 2013

Mutual Funds Try Hard to Hide One Statistic

An RIA we work with shared a short article about how mutual funds try very hard to hide their maximum drawdowns which then makes it impossible to calculate their MAR ratios.  Maximum drawdown is your maximum peak to trough loss.  For example, lets say you put $100 into a mutual fund in January, in August it was worth $200, and then in December it was worth $110.  You actually made money for the year, you started with $100 and ended with $110, but it doesn't feel like it.  In August you had $200 and in December you had $110, you had a $90 drawdown which was 45%.  We have long believed that risk should be measured by maximum drawdown, not nebulous figures like standard deviation, but I have never seen anywhere where you can find drawndown numbers on mutual funds.  We even subscribe to the most sophisticated analytic package Morningstar has, we can run over 500 statistics on mutual funds, but I have never seen it report on maximum drawdown.

Why don't mutual  funds want you to know what their maximum drawdowns are?  Because the numbers look ugly.  From October 2007 to March 2009 the S&P 500 had a 60% drawdown.  Since most equity funds don't beat the S&P 500 it stands to reason that many were much worse.  It is much better marketing for them to show risk measures like standard deviation because most people don't understand that anyway, but they do understand a peak to trough of 60%.

In evaluating any investment the maximum drawdown can be used to calculate the MAR Ratio.  The MAR Ratio is simply the average annual return divided by the maximum drawdown.  For the past 10 years ended 9/13/13 the S&P 500 has an average annual return of about 7.36% with a maximum drawdown of 60%, that gives us a MAR ratio of .12.  If you were evaluating an investment that could return 7.36% on average but could also drop 60% at any time you probably wouldn't take those odds.  MAR ratios should be 1 at a minimum, so if an investment had a 60% drawdown it should have a 60% average annual return.  Now you understand why mutual funds don't want you to know about maximum drawdown and MAR ratio.

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