Understanding the Calmar Ratio: Risk-Adjusted Returns for Hedge Funds

What Is the Calmar Ratio?

The Calmar ratio is a metric used to evaluate the performance of investment funds by comparing their average annual return to the maximum drawdown over a given period. It helps investors assess risk-adjusted returns, focusing on potential losses during downturns. Similar to the Sterling ratio but using a longer time frame, the Calmar ratio offers clearer insights into long-term risk exposure. However, unlike the Sharpe ratio, which considers overall volatility, the Calmar ratio provides a narrower view of risk.

The Origin and Development of the Calmar Ratio

Terry W. Young, a California-based fund manager, developed and introduced the Calmar ratio in 1991. He argued that the Calmar ratio provided a more current performance measure than the Sterling or Sharpe ratios since it's calculated monthly, while they are yearly. The monthly update also made the Calmar ratio smoother than what Young called the "too sensitive" Sterling ratio.

The Calmar ratio is, in fact, a modified version of the Sterling ratio. Its name is an acronym for California Managed Account Reports. Young also referred to the Calmar ratio as the Drawdown ratio.

Advantages and Limitations of the Calmar Ratio

A strength of the Calmar ratio is that it uses maximum drawdown as a risk measure. For one thing, it's more understandable than other, more abstract risk gauges, and this makes it preferable for some investors. In addition, even though it is updated monthly, the Calmar ratio's standard three-year time frame makes it more reliable than other gauges with shorter time frames that might be more affected by natural market volatility.

On the flip side, the Calmar ratio's focus on drawdown means it's view of risk is rather limited compared to other gauges, and it ignores general volatility. This makes it less statistically significant and useful.

Despite being lesser-known, the Calmar ratio's risk-adjusted nature makes it a viable tool for measuring investment performance. In fact, William Sharpe, creator of the Sharpe, won the Nobel Prize in economics in 1990 for his work on capital asset pricing theory.

The Bottom Line

The Calmar ratio, created by Terry W. Young as a modified version of the Sterling ratio, measures risk-adjusted returns by comparing a fund's average annual return to its maximum drawdown over a standard three-year period.

Its strength lies in using drawdown as a clear, simple risk gauge, but it overlooks overall volatility, making it less comprehensive than other metrics. While less known, it remains a useful tool for investors seeking a straightforward view of downside risk.