The Calmar ratio measures investment efficiency on a risk-adjusted basis. A high ratio indicates low risk of significant losses, while a low ratio suggests higher risk. It's calculated by dividing the investment’s annual return (typically over three years) by its maximum drawdown, reflecting performance versus potential losses.
When analysing investment funds, one of the many metrics that investors use is the Calmar ratio. It is one of the few ratios that provide insights into the risk-adjusted returns of an investment relative to its maximum drawdown. In this article, we are going to explore this particular concept, delve into the Calmar ratio formula and look into its various advantages and disadvantages.
What is the Calmar ratio?
The Calmar ratio is a performance metric that helps investors gauge the risk-adjusted returns of an investment fund for a particular period, which is usually 36 months. One of the many key features of this ratio is that it establishes a relationship between the returns generated by a portfolio with the maximum drawdown.
Many investors widely believe that the Calmar ratio is a more effective way to measure risk-adjusted returns since it takes into account the maximum drawdown, which is more relatable compared to market volatility.
The performance of a fund can quickly be determined depending on what its Calmar ratio is. Here is an overview of the different ratios and what they mean.
- Calmar ratio between 0 and 1
This essentially means that its returns from the fund are less than its maximum drawdown. - Calmar ratio above 1
If the ratio of a fund is more than 1, it indicates that the returns are higher than the drawdown, albeit slightly. - Calmar ratio above 3
A ratio of more than 3 signifies that the returns are significantly higher than the drawdown.
Formula of Calmar ratio
Investors use the following Calmar ratio formula to calculate the metric for an investment fund.
Calmar Ratio = Average Annualised Rate of Return ÷ Maximum Drawdown
To calculate the maximum drawdown, investors use the following mathematical formula.
Maximum Drawdown = [(Peak Value - Trough Value) ÷ Peak Value] x 100
Note: Both the average annualised rate of return and the maximum drawdown are calculated for a 36-month period.
Examples of Calmar ratio
Let us discuss a few examples of computing the Calmar ratio so you can better understand this metric.
Example 1
Let’s say a mutual fund scheme has an average annualised rate of return of 12%. Now, suppose that the fund was launched with a value of Rs. 10,00,000, and over the past 3 years, its value peaked at Rs. 11,00,000 and then dropped to Rs. 10,12,000.
The maximum drawdown in this case will be 8% {(Rs. 11,00,000 — Rs. 10,12,000) ÷ Rs. 11,00,000}. The Calmar ratio for the fund over this period comes out to be 1.5 (12% ÷ 8%)
Example 2
You can also use the Calmar ratio to compare two funds. For instance, consider two mutual funds with the following parameters:
- Fund A: Annualised returns of 12%, maximum drawdown of 8% and a Calmar ratio of 15
- Fund B: Annualised returns of 18% and maximum drawdown of 20% and a Calmar ratio of 0.9
In the above case, although Fund B apparently has higher annualised returns, its Calmar ratio is lower, indicating that the fund is riskier. So, investors may prefer Fund A, which offers better risk-adjusted returns.
Components of the Calmar ratio
Now that you know what the Calmar ratio formula is and how to calculate it, let us understand the various components that are involved in the calculation of the metric. Here are the two components of the ratio.
- Annualised rate of return
The annualised rate of return is one of the most important components. It is the average annual return generated by an investment over a specified period. In the case of the Calmar ratio, the period in question is 36 months. - Maximum drawdown
The maximum drawdown, on the other hand, refers to a peak-to-trough decline in the value of an investment during a specified period (36 months). It is the difference between the highest point in a peak and the lowest point of the immediate trough and indicates maximum loss.
Advantages of the Calmar ratio
The Calmar ratio has several advantages. Let us look at some of the key benefits that this metric offers.
- Risk-adjusted returns
The ratio helps investors calculate risk-adjusted returns, which is a more accurate way to measure the performance of a fund compared to just evaluating the returns alone. - Simplicity
Understanding and calculating the Calmar ratio is very easy and straightforward. - Focuses on downside risk
By considering the maximum drawdown, the ratio focuses on downside risk, which is a crucial evaluation factor for risk-averse investors.
Evaluating investment funds based on the Calmar ratio is easy. The higher the ratio is, the better the fund is deemed to be since it essentially indicates that the investment’s returns are higher than its maximum loss.
Calmar ratio vs other measures of risk-adjusted performance
The Calmar ratio is not the only measure of risk-adjusted mutual fund performance. Various other ratios also help assess this aspect of a fund. Let us delve into these metrics and see how they compare against the Calmar ratio.
The Sharpe ratio compares the excess returns from a fund against its risk or standard deviation. So, unlike the Calmar ratio, which considers the maximum drawdown, the Sharpe ratio factors in the overall volatility of the fund. This makes it suitable for comparing mutual funds with different levels of total risk. Also, read about the differences between the Sharpe ratio and the Sortino ratio.
The Sortino ratio compares the excess returns from a mutual fund with its negative standard deviation or negative volatility. This represents the downside risk of the fund. This is quite similar to how the Calmar ratio focuses on the maximum drawdown of a mutual fund.
The Treynor ratio also measures a fund’s risk-adjusted returns by comparing its excess returns with its beta — which is the fund’s volatility relative to the market or the benchmark. So, while the Calmar ratio only accounts for the fund’s internal drawdown, the Treynor ratio accounts for market-linked risk too.
This ratio compares the weighted probability of gains with the weighted probability of losses from the fund. Since it considers various possible outcomes, the Omega ratio offers a more holistic and complete picture of the risk-return potential of a fund than the Calmar ratio and the other ratios listed above.
History of the Calmar ratio
Terry Young, a fund manager from California, developed and introduced the Calmar ratio in 1991. The ratio was intended to be an improved and updated measure to assess the risk-adjusted performance of a fund than other ratios that were used at the time, like the Sharpe ratio and the Sterling ratio.
Disadvantages of the Calmar ratio
As with any performance metric, the Calmar ratio also has its share of disadvantages. Here are some of the key drawbacks.
The insights provided by the ratio are based on historical data. With market-linked investments, historical performance cannot guarantee future returns.
Extreme events can cause significant spikes in volatility. This could disproportionately affect the maximum drawdown, resulting in a potentially skewed Calmar ratio.
The ratio does not take standard deviation into consideration, which many investors feel is a more useful component for fund evaluation.
Interpreting changes in the Calmar ratio
If you are tracking the Calmar ratio of a fund, you need to know how to interpret changes in the ratio. The following pointers can help you with this.
If there is a significant change in the Calmar ratio, it may indicate a change in the fund’s management decisions — which may be favourable (leading to a substantial increase in the ratio) or unfavourable (leading to a significant dip in the ratio).
A sudden and steep increase in the Calmar ratio may indicate that the fund is performing better. Before investing in such a fund, you may want to ensure that this performance can be sustained.
A sudden and large decline in the Calmar ratio may indicate that the fund is no longer performing well. You may need to switch to better fund options if the Calmar ratio remains consistently low.
Conclusion
The Calmar ratio is a useful metric that can help you evaluate mutual funds. However, it is essential to note that although it gives you insights into the risk-adjusted returns of a fund relative to its maximum drawdown. It is not advisable to rely on this ratio alone when making investment decisions. You must also evaluate funds across other risk-adjusted ratios such as the Sharpe ratio, Sortino ratio and Treynor ratio to get a comprehensive overview of the funds.
If you wish to compare mutual funds, the Bajaj Finserv Mutual Fund Platform can help. You can use the dedicated comparison tool to evaluate multiple funds across different key metrics. Additionally, you can use tools such as the SIP calculator and lumpsum calculator to help you determine the right mutual fund schemes to invest in.