CHAPTER 8
Characteristics of Drawdowns, Volatility, and Correlation
In Chapter 7, several key statistical properties for trend following strategies were discussed. These statistical properties take a first look at the performance of trend following across time. This chapter takes a closer look inside a trend following system at three core measures of risk and diversification: drawdowns, volatility, and correlation. These characteristics are examined at the portfolio level. This discussion provides greater insight into how trend following strategies experience drawdowns; into differences between market volatility, strategy volatility, and portfolio volatility; and into how diversification and correlation across markets impact trend following portfolios.
■ Understanding the Properties of Drawdowns
Drawdown measures the loss from an investor’s peak past net asset value (NAV). Given the stochastic nature of return series, drawdowns are a natural part of any return series. In particular, the maximum drawdown over a given period is often used as an important risk measure. Maximum drawdown represents the worst loss an investor could have suffered by buying at the highest point and selling at the lowest. This measurement often gauges the worst case scenario. Other metrics characterize the maximum drawdown itself. For example, many investors are interested in the time to recovery of a drawdown. There are also performance measures that adjust performance as a function of the maximum ...
