Portfolio Management with Drawdown-Based Measures

Abstract

This article analyzes the portfolio management implications of using drawdown-based measures in allocation decisions. The authors introduce modified conditional expected drawdown (MCED), a new risk measure that is derived from portfolio drawdowns, or peak-to-trough losses, of demeaned constituents. They show that MCED exhibits the attractive properties of coherent risk measures that are present in conditional expected drawdown (CED) but are lacking in the historical maximum drawdown (MDD) commonly used in the industry. This article introduces a robust block bootstrap approach to calculating CED, MCED, and marginal contributions from portfolio constituents. First, the authors show that MCED is less sensitive to sample error than CED and MDD. Second, they evaluate several drawdown-based minimum risk and equal-risk allocation approaches within the large-scale simulation framework of Molyboga and L’Ahelec via a subset of hedge funds in the managed futures space that contains 613 live and 1,384 defunct funds over the 1993–2015 period. The authors find that the MCED-based equal-risk approach dominates the other drawdown-based techniques but does not consistently outperform the simple equal volatility–adjusted approach. This finding highlights the importance of carefully accounting for sample error, as reported by DeMiquel et al., and cautions against overreliance on drawdown-based measures in portfolio management.

TOPICS: Real assets/alternative investments/private equity, portfolio construction, performance measurement