Calmar Ratio: How are Hedge Funds Evaluated?

What is Calmar Ratio?

Calmar Ratio is on of risk-adjusted metrics primarily used to assess hedge funds risk management based on returns relative to risk. The Calmar Ratio was developed by Terry W. Young in a 1991 paper published in Futures journal. The name of the ratio comes from the organization Young founded, California Managed Account Reports.

The Calmar Ratio is not the first metric for volatility-adjusted returns; rather, it is a slightly improved version of another ratio, the Stirling ratio. The difference lies in the time frequency, as the Calmar Ratio is calculated monthly, while the Stirling Ratio is calculated annually.

The Calmar Ratio helps investors looking for investments with smooth returns, regardless the noise that may be caused by extremely high returns in the past, which may be associated with extremely high risk as well.

How to calculate the Calmar Ratio?

The Calmer ratio is calculated based primarily on two components: the rate of return and the maximum drawdown, over a period of typically three years. The ratio is calculated according to the following equation:

Where R is the compounded average growth rate (CAGR) achieved by the fund over the study period, which is usually at least 36 months, or three years. MD is the maximum drawdown which is the largest percentage loss recorded by the fund compared to its highest peak during the period.

Calmar Ratio formula and examples

In a simplified example, assume a hedge fund achieved returns of 2%, 5%, and 10%, and recorded a maximum drawdown of 8%. Therefore, the Calmer ratio is calculated as follows:

Some may also use a more in-depth modification to this calculation by taking into account a risk-free return, such as the return on US Treasury bonds or the average deposit interest rate. The risk-free return is subtracted from the rate of return over the period. Therefore, the Calmer ratio becomes, as in our previous example, assuming a risk-free rate of return of 1%:

How to Interpret the Calmer Ratio?

The core of the Calmer ratio is that it expresses the percentage of return achieved relative to the maximum drawdown incurred and the extent to which the hedge fund was able to recover its losses. In other words, it measures the effectiveness of the hedge fund risk management. Below, we discuss the interpreting the Calmar ratio for portfolio management.

Generally, the greater the Calmar ratio, the greater the investment manager's ability to recover the maximum drawdown incurred. For example, a hedge fund with a Calmer ratio of 2 was able to recover double its maximum loss.

Also, a high ratio during a bull market may reflect favorable factors rather than effective risk management, while a low ratio during a crisis may conceal the potential for future recovery.

The previous interpretation may seem insufficient because it lacks a comparative element. To gain a deeper understanding of the Calmer ratio calculation to evaluate the performance of a hedge fund or investment manager, different readings of these ratios should be compared as follows:

• Compare to the historical average of this ratio for the same hedge fund.

• Study the historical evolution of this ratio to measure progress in risk management efficiency.

• Compare to peer hedge funds.

In the following example, we will focus on how we can compare the risk management efficiency of hedge funds. Let's consider the four-year historical performance of three hedge funds, A, B, and C, as follows:

As we can see, fund B achieved the highest average return over the four years and the highest loss in the fourth year compared to the other two funds. However, it also recorded the highest drawdown of 26%, the largest among its peers. Therefore, its Calmar ratio was 0.33, the lowest among its peers, suggesting a relatively high exposure to risk to achieve high returns.

While fund A achieved a modest series of returns with the lowest maximum drawdown compared to its peers, so it has a Calmer ratio of 1.5. This demonstrates the fund's conservative approach – something not typically seen in hedge funds known for their high exposure to risk.

Despite its relatively low returns, it was exposed to minimal risk and thus may be suitable for investors seeking stable income with a low risk tolerance. Low Calmar ratios are particularly common in bond funds or those focused on stocks with stable dividends payouts.

In contrast to the previous two funds, fund C managed to strike a balance between achieving an acceptable rate of return and a seemingly proportionate amount of risk. It did not achieve the highest rates of return, but it did not exhibit the greatest exposure to risk.

Ultimately, this fund's strategy was reflected in its Calmer ratio, which also achieved the highest reading among its peers. This fund may be suitable for those seeking above-average returns without the excessive risk exposure such as fund B.

What Factors Affect the Calmer Ratio?

The Calmer Ratio is influenced by factors that affect its two main components: the rate of return and the maximum drawdown. Changes in market conditions and shocks, or changes in investment strategy and the scoop of the study period can affect the ratio, which in turn can impact decision-making. Some of these influencing factors include:

• Market flash crash: Sudden crashes such as wars or epidemics can amplify the maximum loss. Even sectors that may be considered relatively safe can suffer severe losses, as we saw in the real estate or consumer goods sectors during the pandemic in 2020.

• Risk management strategies and practices: These directly affect both returns and losses, despite exposure to sometimes high levels of risk. Poor risk management can lead to severe losses even in relatively safe investments.

• The scoop of the study: The study period may be limited to years during a bull market, which may make funds with high levels of exposure to risk unjustifiably more attractive, albeit unseen.

What Are the Pros and Cons of the Calmer Ratio?

After understanding the Calmer ratio and how it is calculated and used, we move on to present the most prominent strengths and weaknesses of this risk-adjusted return metric:

Pros

• One of the best risk-adjusted return metrics: The Calmer ratio offers distinct advantages for investors seeking to evaluate risk-adjusted performance with a focus on capital safety and taking into account the impact of severe losses on investment decisions.

• Ease of interpretation: It allows for quick comparisons between different hedge funds or strategies, which may be helpful for those who are not deeply familiar with the market.

Cons

• Unpredictability: The Calmar ratio's reliance on historical data limits its predictive power, as past gains or declines may not reflect future returns or risks, especially in emerging markets or during unprecedented events.

• Ignoring timing: The Calmar ratio ignores the frequency and duration of losses. A fund with multiple smaller losses may have the same Calmar ratio as a strategy with a single, deep decline.

• Exposure to outliers: A single, large loss due to a flash crash, possibly caused by a factor unrelated to market fundamentals, can significantly inflate the maximum drawdown. This can make a fund with relatively stable and strong returns less attractive.

Calmar Ratio vs. Sharpe Ratio vs. Sortino Ratio

The Calmar ratio is not the only one of its kind as a measure of risk-adjusted return. Below, we briefly compare the Calmar ratio with both the popular Sharpe and Sortino ratios:

Calmar Ratio vs. Sharpe Ratio

Both ratios are risk-adjusted return metrics, but they measure returns and risk differently and therefore may not be used in the same context. The Sharpe ratio is calculated by dividing the expected rate of return by the standard deviation of returns that outperform a benchmark or average.

The Sharpe Ratio, however, takes into account broader volatility measure over the study period, rather than focusing solely on the maximum drawdown.

Calmar Ratio vs. Sortino Ratio

The Sortino ratio is another popular measure of risk-weighted return. It is a modification of the Sharpe Ratio, but it is more complex to calculate. Its distinguishing feature is that it focuses on rates of return that exceed a benchmark set by the investor (such as the risk-free return).

It also focuses on volatility resulting from losses, rather than the increase in returns, as in the Sharpe Ratio. With this different approach to measuring risk in the Sortino ratio, it has an advantage over the Calmar ratio, which measures risk simply by calculating it as the maximum decline from the highest peak.

Importance of the Calmar Ratio in Trading

The Calmar ratio may not be limited to comparing hedge fund performance. Calmar ratio is useful for forex and stock traders. For example, the Calmar ratio can be used outside the context described above as follows:

• Portfolio performance measurement: Instead of having multiple hedge funds to compare, you can use it for investment risk assessment using a set of investment portfolios with different holdings using the Calmar ratio.

• Comparing trading strategies: Using the Calmar ratio, you can also compare the performance of your various trading strategies, whether in the stock market or forex. This allows you to obtain a more accurate assessment of your strategies based on volatility-adjusted returns, rather than simply looking at historical returns.

Conclusion

The Calmar ratio is one of the best risk-adjusted return metrics due to its simplicity and ability to compare the performance of hedge funds and investment managers to measure the effectiveness of their risk management. To calculate the Calmar ratio, we use the average return over a period, typically 36 months prior, and the maximum loss from the highest peak recorded during that period are used.

The Calmar ratio is easy to interpret and aids decision-making, but it is affected by outliers and bias resulting from the selection of the study period. Although initially used to evaluate hedge funds, it can be used for investment risk assessment, portfolio performance measurement and comparing trading strategies.