Portfolio Management with Drawdown-Based Measures

Abstract

This paper analyzes the portfolio management implications of using drawdown-based measures in allocation decisions. We introduce modified conditional expected drawdown (MCED), a new risk measure that is derived from portfolio drawdowns, or peak-to-trough losses, of demeaned constituents. We show that MCED exhibits the attractive properties of coherent risk measures that are present in conditional expected drawdown (CED) but lacking in the historical maximum drawdown (MDD) commonly used in the industry. This paper introduces a robust block bootstrap approach to calculating CED, MCED and marginal contributions from portfolio constituents. First, we show that MCED is less sensitive to sample error than CED and MDD. Second, we evaluate several drawdown-based minimum risk and equal-risk allocation approaches within the large scale simulation framework of Molyboga and L’Ahelec (2016) using a subset of hedge funds in the managed futures space that contains 613 live and 1,384 defunct funds over the 1993-2015 period. We 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 in DeMiquel et al (2009), and cautions against over-relying on drawdown-based measures in portfolio management.