What is Return Over Maximum Drawdown (RoMaD)
Return over maximum drawdown (RoMaD) is a risk-adjusted return metric used as an alternative to the Sharpe Ratio or Sortino Ratio. Return over maximum drawdown is used mainly when analyzing hedge funds. It can be expressed as:
RoMaD = Portfolio Return / Max. Drawdown
Introduction To Hedge Funds
BREAKING DOWN Return Over Maximum Drawdown (RoMaD)
Return over maximum drawdown is a more nuanced way of looking at hedge fund performance or portfolio performance in general. Drawdown is the difference between a portfolio’s point of maximum return (the “high-water” mark) and any subsequent low point of performance. Maximum drawdown, also called Max DD or MDD, is the largest difference between a high point and a low point. Maximum drawdown is becoming the preferred way of expressing the risk of a hedge fund portfolio for investors who believe that observed loss patterns over longer periods of time are the best available proxy for actual exposure. This is because these same investors believe hedge fund performance does not follow a normal distribution of returns.
Examples of Return over Maximum Drawdown
Return over maximum drawdown is the average return in a given period for a portfolio, expressed as a proportion of the maximum drawdown level. It enables investors to ask the question, "Am I willing to accept an occasional drawdown of X% in order to generate an average return of Y%?"
For example, if the maximum achieved value for a portfolio to-date was $1,000 and the subsequent minimum level was $800, the maximum drawdown is 20% (($1000 - $800) / $1000). That is a scary number for investors, particularly if they were to bail out at the bottom with their investment 20% lighter. Of course, that is only half the story. Imagine that same portfolio had an annual return of 10%. In that case, you have an investment with a maximum drawdown of 20% and a return of 10% for a RoMAD of 0.5. Now an investor can use that benchmark to compare performance with other portfolios. A RoMaD of 0.5 would be considered the more attractive investment over one with a maximum drawdown of 40% and a return of 10% (RoMaD = 0.25). On the surface, the returns of these two portfolios are the same, but one is much riskier to the downside.
Return over Maximum Drawdown in Context
In practice, investors want to see maximum drawdowns that are half or less of the annual portfolio return. That means if the maximum drawdown is 10% over a given period, investors want a return of 20% (RoMaD = 2). So the larger a fund's drawdowns, the higher the expectations are for returns. As with any metric of evaluation, of course, the performance expectations are tempered by the performance of other investments during the same period. So there are times of challenging market conditions where a RoMaD of 0.25 is actually stellar, all things considered.