The maximum amount a fund would have lost if you bought at its peak and sold at the worst time – its maximum drawdown – can indicate the potential risk to holding a fund for all but the very long-term investor.
For example an investor who had bought a property fund in October 2007 could have lost more than 70 per cent of their investment when the market bottomed out in March 2009 and would still have not recovered these losses.
According to FE Analytics, the Old Mutual Global Property Securities and Standard Life Investments Global REIT funds have the highest max drawdown over the past seven years having both lost more than 70 per cent in the wake of the financial crisis.
They are currently down 26.14 and 14.13 per cent respectively.
Performance of funds over 7yrs
Source: FE Analytics
While ups and downs are the nature of financial markets and funds that don’t have down periods are extremely rare, maximum drawdown is particular relevant for situations where there is need to sell out - such as when the holder of fund dies and their estate may be subject to inheritance tax.
Ben Willis, head of research at Whitechurch Securities, says maximum drawdown is a key metric when deciding to buy a fund but is often over looked by retail investors.
“It is one of a number of things we will look at to make a decision on a fund. It tells you how much from peak to trough when a manager is either wrong or their style has become completely out of favour.”
“It is a metric we look at because although you might expect that some funds have really high drawdown because of how they are positioned and how volatile they are, it is a good way to compare like with like and see which funds in that asset class performed worse.”
However Willis says an important consideration is the period that you are reviewing, particularly if it contains the financial crisis.
“It might make a fund that had little drawdown in 2008 versus its peers look good even though now it is pretty mediocre but is still dining out on the fact that it didn’t fall as much.”
“You would expect over a seven-year period that most funds would have a significant drawdown and that may be an excellent way of looking at a corporate bond fund, for example. However, then again it was – hopefully- a once in a generation event that you might think you don’t need to look at it again.”
Nonetheless, capital protection is a growing concern among managers and investors this year in the wake of mounting macroeconomic concerns and high valuations as well as the looming spectre of war and political risk.
The tapering of quantitative easing and a likely rate rise by central banks around the corner, combined with a UK general election that is too close to call, make it more challenging than ever to foresee which way the market will head.
Geo-political events also continue to be a theme knocking sentiment back, with crises in Iraq, Syria and Ukraine adding risk.
Steven Richards (pictured), manager of the Thesis Optima Balanced and Thesis Optima Growth funds, says he has become more bearish in 2014 as markets have risen.
He has looked to increase exposure to more defensive funds although he didn’t look directly at maximum drawdown.“We raised our cash levels in July to more than 10 per cent; we really went through an uncomfortable period when the FTS 100 went up to more than 6,800 points. Now we are feeling a bit better about it with the market lower,” he said.
“We have also bought more managers this year who are classed as more defensive ie they have a lower standard deviation of volatility figures. We didn’t use max drawdown although the two numbers are closely related.”
He says while maximum drawdown can give some indication to a fund’s ability to protect capital, it should not be used in isolation.
“It can focus your attention to a fund that can fall more than others due to higher conviction holdings although ultimately it is just going to come down to the manager having the right stocks in the portfolio. We don’t focus on it too closely because it is just a historic indicator,” he said.
“Ultimately, you have to take a view on where the market is going to go.”
