Why Commodities Give you an Ulcer (Index)?

New PictureOne of the many things we geek out about here at Attain, is the vast amount of opportunities available to crunch, dissect, and analyze the measure of risk each strategy offers. We’ve covered them all… Sharpe, Sortino, Mar & Calmar, Sterling (well almost all), and even reevaluated an alternative formula for Sortino. We’ve talked about ways to measure risk adjusted performance: how not all volatility is equal, and how it makes more sense to focus and care about the downside volatility more than the upside. Which led us to define and illustrate the two drawdown differences. Which leads us to perhaps one of the best named risk measurements out there: the Ulcer Index.

The Ulcer Index sort of pulls all of this together based on the theory that the pain an investor feels is not just how big, or how long, or how frequent losses are – but a combination of all of those factors. As such, the Ulcer Index measures the downside volatility, frequency of losses, magnitude of drawdown, and length of drawdown together into one number, measuring the overall pain an investor would have felt.

To provide a detailed explanation, we turn to Futures Magazine:

“The Ulcer Index…is calculated as the square root of the average squared drawdown number…

As can be seen by looking at the calculation, the Ulcer Index incorporates every single drawdown on every day of the history. A shallow drawdown that lasts a very long time will contribute a lot to the Ulcer Index because there will be a drawdown number for each of those days; a large drawdown will also be penalized a lot because of the squared factor…

The final number is a measure of the pain that was felt in the strategy over the period because it reflects all of the drawdown experience – not just the maximum drawdown but the frequency, magnitude and duration of drawdowns.”

Essentially, the Ulcer Index sort of normalizes the drawdown experience, where a small, but long drawdown may bring the same pain (have the same Ulcer Index number) as a big, but short drawdown. Like all such risk ratios – the numbers themselves don’t really mean anything, it’s how they relate to each other when measuring different performance profiles against one another.

For example, we calculated the Ulcer Index for the various asset classes in our monthly asset class scoreboard over the past 10 years (Sept. 2003 – Sept. 2013) to see how each lines up in terms of investor pain.

Ulcer Index Table(Disclaimer: Past performance is not necessarily indicative of futures results)
Sources: Managed Futures = Barclay CTA Index, Bonds = Barclay Aggregate Bond Index
Hedge Funds =DJCS Broad Hedge Fund Index, U.S. Stocks = S&P 500,
World Stocks = MSCI ACWI ex US, Real Estate =iShares DJ Real Estate ETF (IYR)
Commodities = DJ USB Commodities Index

It’s good to see that even thought managed futures is in its worst drawdown since its inception (both length and depth), it still remains near the top of list for least amount of investor pain. Conversely, the often volatile and susceptible to huge (and long) drawdown commodity market has an Ulcer Index (a pain number) 10 times that of managed futures, while stocks and real estate aren’t that much better. So enjoy those stock market all time highs while they last, but beware the pain that comes with them.

 










Comments

  1. Wow. You pulled this one out of the archive. Peter Matthews pitched this to me at MFA five years ago. Matthews co-founder of legendary CTA Mint had just launched a new CTA, PJM, based partially on his research into the ulcer index. Unfortunately, I do not think it survived as I can’t find it in any database. The idea was to remove trades with the most risk and only take those with the best risk/reward ratios. Perhaps he just couldn’t get any trade signals.

    Dan C

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Forex trading, commodity trading, managed futures, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.

The entries on this blog are intended to further subscribers understanding, education, and – at times- enjoyment of the world of alternative investments through managed futures, trading systems, and managed forex, and is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument. Unless distinctly noted otherwise, the data and graphs included herein are intended to be mere examples and exhibits of the topic discussed, are for educational and illustrative purposes only, and do not represent trading in actual accounts. Opinions expressed are that of the author.

*The mention of specific asset class performance (i.e. +3.2%, -4.6%) is based on the noted source index (i.e. Newedge CTA Index, S&P 500 Index, etc.), and investors should take care to understand that any index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship and self reporting biases, and instant history.

The mention of general asset class performance (i.e. managed futures did well, stocks were down, bonds were up) is based on Attain’s direct experience in those asset classes, estimates of performance of dozens of CTAs followed by Attain, and averaging of various indices designed to track said asset classes.

It should be noted that past market performance is not indicative of future market movement.No market data or other information is warranted by Attain Capital Management as to completeness or accuracy, express or implied, and is subject to change without notice.

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Past Performance is Not Necessarily Indicative of Future Results. The regulations of the CFTC require that prospective clients of a managed futures program (CTA) receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the client’s commodity interest trading and that certain risk factors be highlighted. The disclosure document contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA.