Hedge Funds - Downside Capture, Drawdown And Leverage
In relation to hedge funds, and in particular those that claim absolute return objectives, the measure of downside capture can indicate how correlated a fund is to a market, when the market declines. The lower the downside capture, the better the fund preserves wealth during market downturns. This metric is figured by calculating the cumulative return of the fund for each month that the market/benchmark was down and dividing it by the cumulative return of the market/benchmark in the same time frame. Perfect correlation with the market will equate to a 100% downside capture and typically is only possible when comparing the benchmark to itself.
Another measure of a fund's risk is maximum drawdown. Maximum drawdown measures the percentage drop in cumulative return from a previously reached high. This metric is good for identifying funds that preserve wealth by minimizing drawdowns throughout up/down cycles, and gives an analyst a good indication of the possible losses that this fund can experience at any given point in time. Months to recover, on the other hand, gives a good indication of how quickly a fund can recuperate losses. Take the case where a hedge fund has a maximum drawdown of 4%, for example. If it took three months to reach that maximum drawdown, as investors, we would want to know if the returns could be recovered in three months or less. In some cases where the drawdown was sharp, it should take longer to recover. The key is to understand the speed and depth of a drawdown with the time it takes to recover these losses. Do they make sense given the strategy?
Leverage is a measure that often gets overlooked, yet is one of the main reasons why hedge funds incur huge losses. As leverage increases, any negative effect in returns gets magnified and causes the fund to sell assets at steep discounts to cover margin calls. Leverage has been the primary reason why hedge funds like LTCM and Amaranth have gone out of business. Each of these funds may have had huge losses due to the investments made, but chances are these funds could have survived had it not been for the impact of leverage and the effect it had on the liquidation process.