Calmar Ratio : Definition, How to Use it & How to Calculate it

Trading concepts

Calmar Ratio

The performance of investment funds measures by the gauge is The Calmar ratio. The investment funds include:

  1. commodity trading advisors (CTAs)

2. hedge funds.

In this post, we will discuss Calmar Ratio and calculate it.

A formula used to measure the performance of any investment fund is as Calmer Ratio. Moreover, It is just like a hedge fund. Investors use this gauge commonly as a risk-adjusted measure.

It is a function to calculate the average of funds compounded at an annual rate return. It is a comparison to the maximum drawdown. The more Calmer ratio is there. As a result, the better it will perform on a risk-adjusted basis. It is during an already set time frame. Additionally, you can say, it is for almost 36 months.

A Brief Intro about Calmer Ratio

The funds that are risk-adjusted are measured through Calmer Ratio. Terry Young, who was a fund manager, was the creator. It was the year 1991. The fund’s maximum drawdown is used by the Calmar ratio. This makes it quite unique. But this thing is also a weakness.

History of Calmar Ratio

When was it created?

The Calmar ratio was develop in 1991 by a California-based fund manager. His name is Terry W. Young. According to his studies, the ratio offered more up to date performance of the funds’ reading. There was a comparison of this ratio with Sharpe or Sterling ratios. It also was having many other measuring gauges.

“Almost too sensitive” Sterling Ratio

The best thing about the ratio is that it is a monthly measuring instrument. Whereas other gauges give the annual report. This ratio is also famous as the “almost too sensitive” Ratio by Young.

It is a modified version of the Sterling ratio. The name of calmer ratio is an acronym for California Managed Account Reports. Moreover, the Calmar ratio is also the Drawdown ratio.

How Do I Calculate Calmar ratio?

Calmar ratio indicates a relationship between return and risk. It is basically a function that people use to measure the maximum drawdown. And expected annual rate of return for the past three years.

This ratio is for assessing the success of several hedge funds. And help in making investment decisions. The higher the ratio will be, the higher returns will be on a risk-adjusted basis. These are for a specific time frame. This time frame is usually 36 months.

Relation between Calmar Ratio and Hedge Fund

An investment fund’s performance is measured through Calmar Ratio. Hedge Funds are a common example. The experts calculate the ratio by comparing it with risk. Moreover, The amount that a system requires for obtaining a return is Calmar Ratio. As a result, this thing helps the investors in balancing the risk appetite. Moreover, The ratio helps to analyze the models or trading strategies. This uses historical data, and the whole process is backtesting.

Calculation of the Calmar Ratio

You can easily determine the Calmar ratio if you take the investment funds that are an estimate of the annual rate of return. These are usually for a term of 3 years. Then, you will have to divide them by maximum drawdown.

Formula: Calmar Ration= Rp-Rf/ Max drawdown

Where:

  • Rf = Risk-free rate
  • Rp = Portfolio return
  • Rp – Rf = Annual rate of return

The meaning of the annual rate of return is how the hedge fund went the whole year. It is a degree to which the portfolio of a fund. It may decrease or increase. You can calculate it as a percentage.

The maximum fund’s loss is the maximum drawdown. It is from peak to bottom over any given period of investment. You can determine it by a simple method. Subtracting the lowest value of the fund from the highest value, and then you will divide the result by the peak value of the fund.

Importance & usage of the ratio

It is a useful and the best tool to compare the return of two different funds. Let’s take an example, suppose that Fund C is having a high rate of return than Fund A. However, Fund C is having a higher Calmar Ratio as we compare it with Fund A. It means that Fund B is a riskier option.

Reduces Risks

The aim of Calmar Ration aims for demonstrating the amount of risk that requires for obtaining a return. As the investors have several risk tolerances, the ratio helps the investors in balancing the risk appetite with the investment decisions.

Smooths Out Over and Under Achievements

In the fund portfolio, the Calmar ratio helps in smoothing out the over-achievements and under-achievements. As the performance results are smooth out, this helps in prospects for attracting the long-term investment.

This ratio also acts as the cautionary signal. If this ratio is a downtrend, the investors need to review the portfolio for deciding whether the downturn is due because of an increase in uncertainty, returns or any other issues.

Changes in Ratio

If there is any big change in Calmar Ratio, it will highlight the effect of actions. Those are against or in favour of any investment fund. Any sudden increase in the ratio is quite a good indicator in the fund. The reason behind this is that it is vulnerable to risk and price fluctuations. As a result, it helps in good performances.

In contrast, if there is any sudden decrease in the ratio, it implies that it affects the performance of the fund. This can happen due to maximum drawdown for annual rate or last 3 years.

Backtesting

Another best part of this ratio is that it is really useful for the backtesting of trading strategies. Investors also use the ratio in combination with the Sharpe ratio and sterling ratio. But you cannot adjust the Calmar ratio for several time horizons. So, it is important that the portfolio has the same period of backtesting while you use the ratio.

Pros and Cons of Calmar Ratio

Better Than Other Risk Gauges

The use of maximum drawdown is the best part about the Calmar ratio, as it is a measure of risk. It has the best and more abstract risk gauges. Moreover, this ratio is quite understandable, and most investors prefer this ratio.

Three-Year Time Frame

Another best thing about the Calmer Ratio is that it has a standard three-year time frame. Although it is updated monthly. This thing makes it more reliable as compared to other gauges. Specially, that have short time frames. These short time frames can be affected by natural market volatility.

Calmar Ratio is Statistically less useful

Coming towards its drawback. Here, the focus of Calmar Ratio on drawdown means that the view of the risk of this gauge is limited. If we compare it to several other gauges. Moreover, it does not consider the general volatility. As a result, his thing makes it less useful and significant.

Lesser-Known Gauge

The nature of the Calmar Ratio is risk-adjusted. That’s why it is used for making measures of possible investment performance. But the main issue is that it is a lesser-known gauge that is used for risk-adjusted returns.

Conclusion

The efficiency of any investment on a risk-adjusted basis gets calculated using the Calmar ratio. If there is a high ratio. Then it means that the investment return is not at risk because of a specific drawdown. Comparatively, the low ratio is an indication that the risk of drawdown is bigger.

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