Understanding Drawdowns: The Reality of Quantitative Investing
If a fund manager tells you they never lose money, run. In quantitative trading, drawdowns are not a bug—they are a feature. They are the cost of doing business in the pursuit of Alpha. The key is distinguishing between a normal statistical drawdown and a broken strategy.
What is a Drawdown?
A drawdown is simply the peak-to-trough decline during a specific period for an investment. It measures the "pain" an investor would have felt if they invested at the absolute top and sold at the absolute bottom.
The Role of Variance
Even a strategy with a Sharpe Ratio of 2.0 (which is excellent) will have losing months. This is due to statistical variance. Market regimes change—volatility expands and contracts. A trend-following system will bleed during a choppy sideways market. This is expected.
Metric to Watch: The MAR Ratio
At Virexan Capital, we prioritize the MAR Ratio (CAGR / Max Drawdown).
- If a strategy makes 30% a year but has a 60% drawdown, it is uninvestable (MAR = 0.5).
- If a strategy makes 15% a year but has a 5% drawdown, it is elite (MAR = 3.0).
How We Manage Drawdowns
- Diversification: We trade uncorrelated assets. When Nifty tech stocks are falling, Gold might be rising.
- Sizing based on Volatility: When market volatility spikes (measured by India VIX), our position sizes automatically reduce to keep risk constant.
- The "Uncle Point": Every strategy has a pre-defined point where we turn it off. If a strategy exceeds its modeled max drawdown by 1.5x, we kill it. No questions asked.
Investing in algos is not about avoiding losses; it is about ensuring those losses are calculated, contained, and compensated for by larger wins.