Analyzing a CTA’s Daily Returns, Part Two: Equity Curve vs Underwater Chart

As mentioned in our first part to this series, at aiSource we are big believers in analyzing a CTA’s daily return data.  In our first part, we displayed how we use a CTA’s daily return data to make a frequency distribution of daily returns.  The frequency distribution gives us a good idea of what type of volatility to expect on a day to day basis, and it displays any outlier days that an investor should be aware of.  In addition to charting the frequency distribution, we are also able to use the daily returns to see a CTA’s equity curve [since inception] and their drawdown (or underwater) chart. 

Seeing a CTAs drawdowns and equity curve using daily returns provides an investor with a much clearer picture of what to expect when investing in a strategy.  Furthermore, graphically displaying the drawdown and equity curve can help an investor visualize what to expect.  Here is a sample graph of a CTA’s underwater chart and equity curve: 

      VAMI - Drawdown Chart

Looking at the drawdown chart (filled in with blue), you can see that historically, this CTA has had a few drawdowns that were close to -10%.  Those drawdowns were recovered quite quickly, and high water mark was reached.  Currently, the CTA is experiencing their largest historical drawdown.  The curve underwater chart recently touched -20%, and the CTA has slightly recovered from that low.  

The real question is “What does the above chart tell us moving forward, and how can it help us make an investment decision?” For new investors, the above chart should signal an “opportunity” to get into the strategy.  Considering that the CTA has just endured their worst historical drawdown, and one that was twice as large as their previous historical worst, it should mean that it is likely a good time to enter the strategy; similar to “buying low” in stocks. Chances are that the drawdown may continue lower, but the probability of getting significantly more severe are improbable. Furthermore, by analyzing the above chart, investors not only can get a sense of when is a good time to enter the strategy, but also how long it takes for the strategy to recover from its drawdown’s.

 The red line above shows the VAMI (more commonly known as the equity curve) peaked somewhere around 2300, which means the CTA had accumulated a total return close to 130%.  Therefore, the recent drawdown of 20% pales in comparison to the run-up that the CTA has experienced since inception.  Furthermore, the VAMI line shows that despite drawdowns along the way, the CTA tends to recover nicely with an upward sloping VAMI line. The most recent “bump” in the curve is the most severe one the CTA has experienced, and based on the historical pattern there should be confidence that the curve will recover.