How Long Does It Take to Recover from a Drawdown?

43 Pages Posted: 22 Apr 2013 Last revised: 29 Jun 2014

See all articles by Marcos Lopez de Prado

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; AQR Capital Management, LLC

Date Written: April 21, 2013

Abstract

* 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.

Keywords: drawdown, time under water, stop-out, triple penance, serial correlation, Sharpe ratio

JEL Classification: G0, G1, G2, G15, G24, E44

Suggested Citation

López de Prado, Marcos, How Long Does It Take to Recover from a Drawdown? (April 21, 2013). Available at SSRN: https://ssrn.com/abstract=2254668 or http://dx.doi.org/10.2139/ssrn.2254668

Marcos López de Prado (Contact Author)

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

AQR Capital Management, LLC

One Greenwich Plaza
Greenwich, CT 06830
United States

HOME PAGE: http://www.aqr.com

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