What is Calmar Ratio?
In simple terms, Calmar Ratio is defined as a ratio of the average annual rate of return and the maximum drawdown risk of a portfolio (Hedge Fund) and measures the risk and return of the fund, as it enables the investors to see the potential opportunity in a particular fund and also its potential loss risk. It was invented by Mr.Terry W. young in 1991 in the United States and is the short form for the company of Terry Young named “ California Management Account Reports”.
It is more used in the selection of a mutual fund or a hedge fund in order to evaluate the performance of the two and take a decision on the investment.
Calmar Ratio Formula
*Here both the numerator and denominator are calculated for the past 3 years.
Examples on Calmar Ratio
The following are the examples of Calmar Ratio.
Example #1
Suppose A hedge fund has an annual rate of return for the past 3 yrs is 25%. The fund started its activity with $10,000 which rose to $25,000 and then drop to $8,000 due to crisis situations.
Solution:
Here the maximum drawdown needs to be computed for the fund in the following way :
Maximum Drawdown = ($25,000-$8,000)/ $25,000 = 68%.
Based on the above information, we can calculate the Calmar Ratio as below :
= 25%/68%
Calmor Ratio = 0.3676.
Example #2
Suppose there are two Funds, Fund A and Fund B. Below are the details of each fund. Which fund would be more beneficial for the investor to invest.
Solution :
Calmar Ratio of Fund A can be calculated using the above formula as,
= 25%/68%
Calmar Ratio of Fund A =0.37
Calmar Ratio of Fund B can be calculated using the above formula as,
=20% / 40%
Calmar Ratio of Fund B =0.5
In the above example, an investor would be tempted to go for fund A, since it gives a higher annualized rate of return as compared to fund B. however if we compared the ratio of both the funds, Calmar ratio of fund b is higher as compared to fund A. Hence fund A is riskier than fund B since it is more exposed to fluctuations in the NAV.
Advantages of Calmar Ratio
It is one of the most important Ratios used by the Analyst and the Fund Managers to ascertain the Performance of the Fund and compare the same with its peers who are giving high Returns. Below mentioned are some of the major advantages :
- It gives a clear picture on the risk and returns relationship in the fund to the investors to invest their money cautiously
- It highlights the level of fluctuations or variations in the prices on a periodic basis giving a clear picture of the price stability of the fund
- Higher the ratio more performing the fund and lower the Calmar ratio less performing the fund and more prone to deviations or fluctuations.
- Gives the fund manager an understanding of the fund performance and a signal about the funds who have a low Calmar ratio and needs to be monitored further closely.
- Gives an investor a guide in selecting their investment strategy as it also takes into account the drawdown that has happened in the past 3 years.
Disadvantages of Calmar Ratio
- It considers maximum drawdown instead of the standard deviation of the portfolio which is a more relevant component in decision making.
- It is similar to the Sharpe ratio.
- It takes only a 3 year period in order to calculate the Calmar ratio.
- Most of the stocks are cyclical stocks which perform only in that particular period hence to compare their performance with the past 3 years would not be the right criteria.
Limitations
- It is a mathematical tool and does not take into account the behavior of the Sector.
- It does not take into account the standard deviation of the stock or the fund.
- It does not take into account the future projections of the stock or the fund.
- It does not take into account the new elements or the government policies ahead that will have a massive impact on the stock or the fund.
Points to Note about Change in Calmar Ratio
- A significant change in the Calmar ratio will suggest the ongoing performance of the fund and highlight the impact of the decisions taken in favor of or against the fund.
- A sudden rise in the Calmar ratio is a positive sign for the fund as the same is less prone to risk and deviations in the prices/nav and has started performing better.
- Alternatively, this implies for the sudden fall in the Calmar ratio. It signifies that either the performance of the fund is affected due to the annual rate of return or the maximum drawdown over the past 3 years.
- As far as the investors are concerned, it would be better for them to stay away with the fund who has experienced a sudden fall in the Calmar ratio although it may give higher returns and invest in the fund who has shown a sudden increase in the Calmar ratio since the performance of the fund will now start improving in the long run.
Conclusion
Calmer Ratio is one of the most important tools to identify the correct fund to invest in for the investors and taking an action or monitoring further the fund who has a lower ratio from the fund managers point of view. however other macro factors like govt policies, news element, federal bank policies, and SEC regulations also need to be taken into account while deciding upon the fund performance instead of only considering the Calmar ratio for analysis and ignoring all other factors.
Last but not least, it is a good statistical tool to have a glimpse of the fund or the stock and its financial performance.
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