Calmar Ratio Explained

Can you imagine 100 thousand million stars? What about 125 billion galaxies?

What about the billions of years that information requires to travel from distant stars to Earth?

Okay, we can’t comprehend it either so let’s try something a bit more manageable. Can you wrap your head around the scale of our planet? 🌎

While the information on this vast, cosmic level is fascinating and useful for science, it isn’t quite so practical for the average person. The Calmar ratio follows this rationale.

If we say that the market is the universe, then a 10-year period could be a galaxy, and a year could be a star system not unlike ours. While astronomy and the market did collide in 1989 when a Solar flare brought down the Toronto stock exchange for a while, these scales are so large that it takes a good long while for any information to really reach us.

Thus, the Calmar ratio focuses on the Earth, it shows you the changes and performance of an asset on a month-to-month basis. Now this is tangible and immediate data that you can really work with.

Let’s learn more. 👇

What is the Calmar Ratio🤔

The Calmar ratio is a metric for evaluating an investment’s performance on a risk-adjusted basis developed by a California-based fund manager Terry A. Young. It is somewhat unique in that it heavily emphasizes maximum drawdown.

This type of risk assessment remains highly relevant as it goes a long way in helping you steer clear of high-return yet too high-risk investments—which is likely only to grow in importance as the FED takes the steps to remove stimuli imposed on the market amidst the covid-19 pandemic.

While steps like this are necessary to ultimately stabilize the economy, they usually make it far more volatile in the meantime. Considering the market is generally a very lively place, a particularly important feature of the Calmar ratio is that—unlike most of its competitor metrics—it is calculated on a monthly basis making it far more reactive to performance changes.

Variants of Calmar Ratio 👇

While the Calmar ratio can be very helpful—especially when performance is changing quickly—it is important to note that there are multiple versions of this metric. The main two variants mimic the old Sterling ratio which also has its own deviations.

The first formula takes only the annual average rate of return, while the second one takes a note from the Sharpe ratio and first subtracts the risk-free return rate from the average return of whatever you are measuring. 

How to Calculate the Calmar Ratio 👨‍🏫

The first thing to note about calculating the Calmar ratio is that it is determined monthly for a period of 36 months—three years. This is true for every kind of this metric and should be kept in mind when taking the averages and the max drawdown. 

This timeframe should also be remembered when using the Calmar ratio in conjunction with other similar measurements. It makes little sense to use it together with a 10-year-determining Sharpe ratio.

As we’ve established, the Calmar ratio has two versions and thus two formulas so let’s look at both of them

Calmar Ratio v.1 📘

The first version of the Calmar ratio deals only with the annual average rate of return and goes:

So, let’s say that our annual return is 15% while our maximum drawdown is 44%.

Calmar Ratio v.2 📙

The second formula takes a note from the Sharpe ratio, and other Sharpe-like equations and subtracts the risk-free rate of return from the annual average to get the Calmar ratio.

Here, the rp is the portfolio’s return—so continuing our example 15%.

The rf on the other hand represents the risk-free return rate which is a concept problematic enough that it merits a closer look.

Namely, there are no truly risk-free trades on the market since every investment carries some risk—both coming from inside the stock market such as sudden changes in investor’s interests and strategies, and from the outside like major scandals, inflation, bankruptcies, etc.

That being said, the industry-standard benchmark for risk-free return rates tends to be treasury bonds, but you could also argue for using blue-chip stocks—which are probably the safest option among all shares.

Either way, you should be mindful that depending on the chosen benchmark the results may vary widely. This is especially true when using stocks rather than bonds as even monolithic well-established companies like Coca-Cola remain active often topping expectations like in the third quarter of 2021 and thus often prompting bigger return rates than expected.

That being said, bonds aren’t immune to unpredictability which is something likely to only increase in relevance throughout the post-pandemic market as the FED increases tapering as a part of its effort to pull back on pandemic-era aid.

Furthermore, additional deviations can also be expected under the best of circumstances when sticking to the far more common bonds as they also sometimes vary in rates from variant to variant. So, let’s take a look at the Calmar ratio for our example using a more conservative bond-like risk-free return of 2.5% and a more unorthodox 7% that could be expected from blue-chip stocks.

Conclusions of the Calculations 💡

It is quite obvious that the Calmar ratio can vary widely depending on the formula and parameters you choose. While this might appear as a major problem it tends not to be as—much like the Treynor ratio—it is primarily a comparison tool.

This means that under most circumstances when you find a Calmar ratio of an investment whether online or through one of the many most popular stock brokers, the parameters they’ve chosen should be the same.

As long as you are looking at data from the same source, the results should be valid and representative of the genuine differences in the efficiency of various considered trades.

Still, it is very useful to know how to get the ratio yourself as it can make it far easier to spot something is foul in case of data manipulation. The other good thing about knowing the formulas is that you can better tailor the calculation for your needs—especially as the Calmar ratio is less popular than others like the Sortino ratio and might be less readily available.

What is a Drawdown in Relation to the Calmar Ratio 🤨

The first important thing to note about drawdown is that it isn’t the same as loss. Loss tends to be considered by most investors as a value decrease from the initial investment. Drawdown compares the peak and low values pretty much entirely disregarding the initial investment.

To put this as an example: You buy a certain security for $10. That security then falls to $8 before rebounding to $12. Most investors would see this as an unrealized loss of $2, and an actual gain of $2—your $10 is now worth $12, yay.

Opposite to this is the drawdown which would, in this case, be $4. The price had a peak of $12 and was at its lowest at $8 and it’s only that difference that matters. This drawdown would only be considered overcome once the price breaches $12—so a minimum of $12.01 is needed.

Maximum drawdown is considered a measure of risk and it’s aimed at helping you with capital preservation. Generally speaking, the lower the max drawdown the better. However, if the measured period contains a major bear market or a crisis a high maximum drawdown can be acceptable.

If the maximum drawdown of your measured fund or security is 60%, but the overall drawdown of the market and its biggest indices is 80% that 60% still vastly outperforms the benchmark.

How to Calculate Drawdown for the Calmar Ratio 🧮

The maximum drawdown measures the greatest decrease in price before the latest peak is achieved within the time frame we are looking at.

So, let’s say that a fund had a value of $1.000.000 when you invested in it. Later, it falls to $650.000 before rising to $900.000 and falling again to $500.000 and finally going up to $1.050.000.

Let’s figure out the maximum drawdown of this fund using the formula.

So, the max drawdown of this particular fund would be 50%.

Using Calmar Ratio in Investing 💰

While the most obvious use of the Calmar ratio is comparing potential investments (the one with the highest score should be able to earn you the most money while losing the least), it has some far more interesting uses. One very cool thing about it is that it can be used both to analyze the past and peer into the future.

Since it is measured on a monthly basis, you can use it to track the performance of mutual funds, ETFs, or other investments you are interested in over time. This has double utility. First, it can show you their historical efficiency—for 36 previous months—and it can tell you a bit about their future performance. 📅

If you notice that the Calmar ratio of an asset is increasing, it tells you that whatever the management is doing is probably good. It is likely to keep increasing, making it a viable investment even if it was subpar in the past.

Likewise, a decreasing Calmar ratio indicates that something foul is afoot. Whether it be a prolonged lapse in judgment, changing management, or anything different, the investment simply isn’t that reliable anymore. While this shouldn’t immediately get you to get rid of that part of your portfolio, it certainly is a sign you should start keeping a closer eye on it.

This approach can work for index funds as well. In some ways, it can work even better for these passive investments as they tend to follow a market index—which has a calculable Calmar ratio. Thus, you can both see whether the ratio is increasing or decreasing over time and you have a concrete benchmark to compare the given fund to. 📊

The Calmar ratio is also useful when reassessing your own portfolio and trading strategy. The principle is the same. If your ratio is staying stable or going up, and if it is mimicking or outperforming its benchmark, it means that you probably have little to fear and everything is being well-managed.

On the other hand, if you are being outperformed by the benchmark, or have a decreasing ratio it might be time to return to the drawing board.

Calmar Ratio Advantages 🏆

While the Calmar ratio isn’t exactly well-known, it tends to be lauded when it does pop up. This is for a very good reason as we’ve well established. 

The ratio is pretty reactive to changes, so it can give you a heads-up before most other ratios. It is useful for assessing the past performance of your portfolio or most any other investment. It might even tell you a bit about future performance.

This rather unique way the Calmar ratio is calculated has been pointed out and praised by Peter Brandt. He stated in an interview with Business Insider back in 2011 that, unlike the Sharpe ratio which can lull an investor into a false sense of stability, the Calmar ratio shows the true churning volatility of the market.

And while the market has since then been doing pretty good overall, some would argue that this has been the fact to a large extent due to luck. Thomas H. Kee Jr. has pointed out that the market stimulus has been successful primarily because there was virtually no inflation, and that the post-pandemic market is a ticking time bomb. ⌛

Additionally, there have been some tumultuous events over the years. The most recent and bombastic was probably the GameStop craze which famously drove several hedge funds under. One could argue that a more reactive tool like the Calmar ratio could have seen the actual volatility being built up by all the shorting, and probably naked shorting being done, as well as other high-risk practices.

Furthermore, it is quite easy to read—the bigger the number, the better—and there is just something tangible about its month-to-month calculations that most other such metrics don’t offer. The Calmar ratio also considers an often-overlooked factor—the maximum drawdown.

With all these advantages, it would be easy to jump straight to using the Calmar ratio and only the Calmar ratio.

Calmar Ratio Limitations 🚧

However, few things are utterly without stain, and likewise, this ratio has a set of limitations. Its great focus on drawdown can somewhat blindsight you. Standard deviation—the measure of a stock’s movements outside expectations both upward and downward—is often a more relevant metric when building your portfolio.

Another downside of the Calmar ratio is that—unlike some other indicators used when analyzing the market both manually and through stock analysis software—it doesn’t predict future performance. Remember, while it can help you gauge how an investment will perform, any conclusions you draw will be your own.

Similarly, much like many others, it is a mathematical formula and can’t account for everything happening in the real world—it has no way of knowing if a poll is going to tell Musk to sell a 10% stake in Tesla, and has no information on any other such shenanigans.

The Calmar ratio also somewhat suffers from its parameters. This primarily concerns the risk-free portion in the formula—a term both arguably nebulous and open to interpretation. That being said, this should usually be an issue when you’re rating an individual company without comparing it to another, similar stock.

A bigger number is better whenever comparing and should yield acceptable results as long as you’ve picked the same risk-free return rate for every measured asset. Still, the fact that a portfolio is outperforming a benchmark doesn’t mean that the benchmark is good—thus a lack of a fully reliable static desired score can still present an issue.

Calmar vs. Other Ratios ⚖️

Finally, a big thing to remember about the Calmar ratio is that it shouldn’t be used alone. While you should use analysis tools of every shape and size, let’s look at the relationship between the Calmar ratio and some others like it. 

Calmar Ratio vs. Sharpe Ratio 🔎

Terry Young considered his ratio to be the main alternative to the Sterling ratio—which he called too sensitive—and to the Sharpe ratio which he considered too slow. Still, the Sharpe ratio is considered the Calmar ratio’s main competitor, one that mostly overshadows it, so how do they compare?

Two main differences between the two and, some would say weaknesses, of the Sharpe ratio are that it is calculated yearly and uses standard deviation in its formula. The first of these makes the Calmar ratio faster to respond to the actual state of the market.

The second dilutes the risk factor of an investment while simultaneously punishing an investment for upward deviations—unexpected gains generally welcomed by the investors. As we’ve mentioned, Peter Brandt likened this to giving you a false sense of security and promoting passivity and constancy while penalizing skillful exploitation of trading opportunities.

While this would make the Calmar ratio seem like the clear winner, it shouldn’t be forgotten that the Sharpe ratio is more popular. Ultimately, the way people direct their money has the biggest impact on the market. While the actual investing has traditionally been the province of professional managers, this is increasingly changing.

The power of public opinion on an asset is well-demonstrated in the fact that Bitcoin remains the most popular cryptocurrency despite analysis showing Etherium to be the better performer. For this reason, the fact that the Sharpe ratio is so popular can alone turn its predictions into self-fulfilling prophecies—completely disregarding the actual merits of the Sharpe and Calmar ratios (although this might change in the future).

The Calmar Ratio vs. the MAR Ratio 🕵️‍♂️

Another ratio very similar to Calmar is the MAR ratio. This ratio predates the Calmar ratio by a bit and is very similar—it takes the compound annual return rate from inception and divides it by the maximum drawdown from inception.

While this makes the MAR ratio able to give you a more complete picture, the Calmar ratio is generally preferred. If you are comparing two funds where one has existed for 30, and the other for 10 years, the MAR ratio doesn’t give you useful data. The 30-year-old fund is at a natural disadvantage that the Calmar ratio annuls by putting both investments on equal footing—36 months.

On the other hand, if you are looking at investments of equal age, there is some merit to checking their MAR ratio—especially if they are relatively new, or if they didn’t go through many management changes.

Fortunately, you don’t have to stick to one ratio exclusively. Much like the modern portfolio theory emphasizes the diversification of assets, we tend to always argue in favor of diversifying your tools.

You can and should run any portfolio through the gauntlet of many similar and dissimilar ratios and indicators before reaching a final decision. You should also remember the limitations of every purely mathematical tool and keep a close look at external factors. 

Few formulas can even hope to claim to be able to predict the financial repercussions of the presidents of the USA and China meeting at a summit—or even know such things happened.

Conclusion 🚩

There certainly are many reasons why the Calmar ratio is so favored among those aware of its existence. Its punctuality can often prove precious and its focus on the drawdown really helps separate the wheat from the chaff.

However, especially if this metric ends up serving you well, you should remember to not overly rely upon it. Much like the Sharpe ratio can give an investor a false sense of stability, the Calmar ratio can blind you to the numerous other important factors in the market—and complacency is seldom good.

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