Premium Market Analysis, Trader Education, Software and Trading Strategies

Trader education, Trading Strategies

Common Sense Analysis of Strategy and Fund Performance

Money is important but also time. There is also the aphorism “time is money”. When looking at strategy and fund performance, common sense does a good job.

Common sense is often lost in advanced statistical analysis. Using common sense offers a practical way of evaluating strategy and fund performance. Some of the key parameters are listed below:

  1. Annualized return
  2. Drawdown profile
  3. Recovery time
  4. Leveragability
  5. Performance ratios
  6. Time irreversibility

1. Annualized return

The strategy must offer an acceptable annualized return subject to constraints. Obviously, very low annualized return is undesirable but also high annualized return that comes at high risk is also undesirable and even more so. Note that even if annualized return is low, the strategy may be acceptable due to the leveragability it offers. More about this in #4 below.

2. Drawdown profile

Many funds and strategy developers state the maximum drawdown but that offers a measure of historical maximum drop from all-time highs. The historical drawdown profile is way more important because it offers an extended view of performance rather than just a snapshot. More about this below.

3. Recovery time

Recovery time from drawdown is an important metric and feature. If it takes a few years to recover from 20% drawdown, then the strategy or fund may cause uncle point to traders and investors. For example, ARKK has been in a drawdown for about a year since the all-time highs.

Note that ARKK compound annual return peaked at 40.5% but maximum drawdown is currently at 54%. Some make the naïve claim that despite the high drawdown the annualized return of the ETF since inception is still 20.5%. See #6 below for the reasons this is a naïve claim.  The drawdown profile of the ETF shows that about 10% of the time the drawdown has been larger than 33%; this is a high risk drawdown profile that can cause uncle point depending on risk aversion profile.


 

4. Leveragability

Why is leveragability important? It is because if the drawdown profile remains acceptable under leverage, then the probability of a large loss in the future is lower. It does not mean that necessarily the strategy or fund performance will be leveraged but that it can accommodate a larger-than-expected drawdown without causing uncle point or even ruin. Apparently, this is the reason many risk averse investors have a larger allocation in Treasury Bonds they keep them to maturity.

5. Performance ratios

Some performance ratios used for strategy and fund performance evaluation can be misleading. One of them is the Sharpe ratio. For example, Sharpe of 1 can mean 10% excess return divided by 10% volatility or even 30% excess return divided by 30% volatility. In a similar way, MAR (annualized return divided by maximum drawdown) of 1 can mean 10% annualized return divided by 10% maximum drawdown or 30% annualized return divided by 30% maximum drawdown. It is always important to evaluate the significance of dimensionless ratios in the context of actual performance and specifically #1 – #3 above.

6. Time irreversibility

It’s common sense time cannot be reversed. Yet, some strategy developers and fund managers point to past performance in an effort to justify current underperformance. This is of no consolation to those who started using a strategy or invested in a fund just before the drawdown. No one can travel back in time to realize the benefits of past performance. This is why #2, drawdown profile, is important.

“We are down 25% year-to-date but last year we made 60%.”

The above is a frightening statement and those who make it forget to account for the investors or traders who invested in a fund or traded a strategy just before the drawdown. Those bagholders, if haven’t reach uncle point yet, cannot go back in time. Smoothness of equity is of paramount importance.

“But CTAs made in excess of 20% in the 90s!” Someone once told me.

Sorry, this is 2022. Investing is not about history, is about the future.

To summarize, advanced statistical analysis of performance and fancy ratios are nice for filling marketing brochures and blog pages but common sense evaluation is probably the most robust way practitioners have used all along and will continue to use.


Premium Content 15% off for blog readers and Twitter followers with coupon PAL15


Disclaimer:  No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

Charting and backtesting program: Amibroker. Data provider: Norgate Data

If you found this article interesting, you may follow this blog via RSS or Email, or in Twitter.