What Is Relative Drawdown and How Is It Calculated?
Explore relative drawdown to understand how an investment performs during market downturns relative to its benchmark.
Investors seek to understand how their portfolios perform, particularly during market downturns. While common measures like absolute drawdown highlight the peak-to-trough decline of an investment, relative drawdown offers a distinct perspective. This metric assesses an investment’s decline against a chosen market benchmark, moving beyond its individual performance. Relative drawdown helps investors gauge how well their investment preserves capital or mitigates losses during broader market declines.
Understanding Relative Drawdown
Relative drawdown quantifies the percentage decrease from an investment’s peak to its subsequent low, measured against a relevant benchmark or index. This metric shows how an investment performs during market stress, not in isolation, but compared to its market. It highlights whether an investment underperforms its benchmark during a downturn, indicating a relative loss of value. The “relative” aspect assesses an investment’s resilience by comparing its decline to its market peer group over the same period. For instance, if an investment falls by 15% while its benchmark falls by 10%, its relative drawdown would indicate this greater decline.
This metric differs from a simple maximum drawdown, which measures the largest percentage drop from a portfolio’s highest to lowest value, without external comparison. Relative drawdown offers a comparative view, useful for evaluating a fund manager’s ability to navigate adverse market conditions. It helps investors understand if an investment truly diversifies or if its performance closely mirrors, or even amplifies, the market’s negative movements. Selecting an appropriate benchmark is crucial, as it provides the standard against which the investment’s downside performance is measured.
Calculating Relative Drawdown
Calculating relative drawdown involves tracking the performance of an investment and its chosen benchmark over time, focusing on their comparative movements. One approach involves observing the ratio of the investment’s value to the benchmark’s value. As this ratio fluctuates, a relative drawdown occurs when this ratio declines from a previous high. The lowest point this ratio reaches after a peak represents the maximum relative drawdown.
A simplified formula to identify this relative decline is: (Investment Value / Benchmark Value) – 1. This calculation, monitored across a period, reveals how much the investment has underperformed or outperformed the benchmark. To illustrate, consider an investment and its benchmark both starting at $100. If the investment drops to $80 and the benchmark to $90, the ratio (Investment Value / Benchmark Value) is ($80 / $90) = 0.8889. If the ratio’s previous high was 1.0, the relative drawdown from that peak is -0.1111, or an 11.11% relative drawdown, indicating the investment lost 11.11% more value than the benchmark during that period.
To find the maximum relative drawdown, identify the highest point of this (Investment Value / Benchmark Value) ratio, then locate the lowest point the ratio subsequently reaches before recovering to a new high. This lowest point represents the deepest underperformance relative to the benchmark. This method provides a clear measure of how an investment’s downside performance compares to its peers or the broader market.
Interpreting Relative Drawdown Values
Interpreting relative drawdown values provides insight into an investment’s behavior during market stress, specifically how it performed compared to its benchmark. A high relative drawdown percentage indicates significant underperformance by the investment when the benchmark was also declining. For example, a 15% relative drawdown means the investment’s decline was 15% greater than that of its benchmark. This suggests that the investment offered less protection against market downturns than its comparative index.
Conversely, a low or even negative relative drawdown suggests better resilience or outperformance relative to the benchmark during a market decline. If the investment’s value fell less than the benchmark’s, or even rose while the benchmark fell, the relative drawdown would be smaller or positive, indicating superior downside protection. This metric is a historical measure, showing how an investment managed downside risk. It helps investors assess whether an investment truly acts as a diversifier or largely follows broader market trends, especially during challenging economic periods.