How Long Does It Take to Recover from a Drawdown?
Marcos Lopez de Prado
Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC
April 21, 2013
* Investment management firms routinely hire and fire employees based on the performance of their portfolios.
* Such performance is evaluated through popular metrics that assume IID Normal returns, like Sharpe ratio, Sortino ratio, Treynor ratio, Information ratio, etc.
* Investment returns are far from IID Normal.
* Conclusion 1: Firms evaluating performance through Sharpe ratio are firing up to three times more skillful managers than originally targeted. This is very costly to firms and investors, and is a direct consequence of wrongly assuming that returns are IID Normal.
* Conclusion 2: An accurate performance evaluation methodology is worth a substantial portion of the fees paid to hedge funds. There is a 20% loss of the drawdown for every false positive. For a large firm, this amounts to tens of millions of dollars lost annually, as a result of wrongly assuming that returns are IID Normal.
Number of Pages in PDF File: 43
Keywords: drawdown, time under water, stop-out, triple penance, serial correlation, Sharpe ratio
JEL Classification: G0, G1, G2, G15, G24, E44
Date posted: April 22, 2013 ; Last revised: June 29, 2014