Maximum drawdown: the risk measure that matters to trustees

Insights

Why volatility, beta and tracking error miss the point, and how a single percentage line in the IPS protects trustees and beneficiaries when markets fall

5 mins

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Risk & Compliance Monitor Connect

Author

Tom Wiseman

CEO

Tom is the Chief Executive Officer of Enhance Group overseeing our multi-jurisdictional Monitor and Select solutions from our Jersey headquarters.

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Investment risk has a hundred metrics. For trustees, only one of them is the right starting point: maximum drawdown, the largest peak-to-trough percentage decline a portfolio has suffered (or could suffer) over a defined measurement period. It is the risk measure beneficiaries actually feel, the one regulators and auditors understand, and the one that produces a defensible line in the investment policy statement when a market dislocation arrives. This article explains what maximum drawdown is, how it is calculated, what sensible levels look like for cautious, balanced and growth mandates, and what history tells us about how bad it has been, and could be again.

Why drawdown is the risk measure that matters to trustees

Investment risk is measured dozens of different ways: volatility, beta, tracking error, value-at-risk, downside deviation etc etc. Each has its place in a portfolio manager’s toolkit. None of them, on their own, are the right starting point for a trustee. Trustees need a measure that beneficiaries feel directly, that regulators and auditors understand intuitively, and that translates into a defensible line in an investment policy statement.

That measure is maximum drawdown. When a beneficiary objects to a 25% loss, the conversation is not about volatility, it is about how much money the portfolio has fallen from its peak. When a trustee is asked to defend the manager’s risk-taking, the question is not about the Sharpe ratio, it is whether the portfolio’s worst peak-to-trough loss was inside or outside beneficiary tolerances. Drawdown is the risk measure trustees are held to account against.

Maximum drawdown is the largest percentage decline observed in a portfolio’s value, measured from a peak to the subsequent low before a new peak is reached. It is a backward-looking measure that takes the worst path the portfolio has actually walked, and reports it as a single percentage.

The calculation is straightforward. Track the portfolio’s value through time. Each time it sets a new high, mark that as a peak. From each peak, find the lowest subsequent value before the next new high is reached, that is the trough. Calculate the percentage fall from peak to trough. Repeat for every peak-and-trough pair in the measurement window. The biggest of those falls is the maximum drawdown.

A worked example. A portfolio is worth £1,000,000 on 1 January, peaks at £1,200,000 on 30 June, falls to £960,000 on 30 September, then recovers to £1,150,000 by 31 December. The maximum drawdown for the year is 20% (the fall from £1,200,000 to £960,000), even though the portfolio finished the year up 15%.

A drawdown limit only does its job if it is set deliberately, with the mandate’s risk profile in mind. The right number is not universal, it depends on the time horizon, the income needs, the tax position and the beneficiary circumstances of each particular portfolio. But broadly speaking, the table below gives illustrative levels that align with the three most common risk profiles trust portfolios are run to.

Risk profile	Illustrative max drawdown limit	Typical asset mix (illustrative)
Cautious	–10%	Predominantly fixed income, cash and lower-risk diversifiers
Balanced	–15%	Roughly equal balance of equities and fixed income, plus alternatives
Growth	–20%	Predominantly equities, with fixed income and alternatives playing a smaller role

These are illustrative, not prescriptive. A defensive segregated mandate run for an income beneficiary may justify a tighter limit than the Cautious profile suggests; a long-horizon growth mandate held for the next generation may tolerate a wider limit than the Growth profile suggests. The point is that whatever number lands in the IPS should be the result of a deliberate conversation between trustee and investment manager, not a default carried over from a template.

History is the trustee’s most reliable guide to how bad drawdowns can be. The figures below are illustrative reminders, not predictions, but they should anchor any conversation about what drawdown limits are realistic to defend and what level of resilience portfolios need to be built for.

Event	Asset class	Approx. peak-to-trough drawdown
Global Financial Crisis (2007–2009)	S&P 500	c. –55%
Dot-com bust (2000–2002)	S&P 500	c. –49%
Oil crisis bear market (1973–74)	S&P 500	c. –48%
Black Monday and aftermath (1987)	S&P 500	c. –33%
COVID-19 (Feb–Mar 2020)	S&P 500	c. –34%
2022 inflation shock	Bloomberg Global Aggregate Bonds	c. –20%

Two of these reward special attention.

The Global Financial Crisis (the ‘Credit Crunch’). The 2007–2009 episode is the modern benchmark for what a deep, prolonged equity drawdown looks like. The S&P 500 fell continuously for 17 months from October 2007, bottoming in March 2009 at roughly 55% below its peak. Even diversified balanced portfolios, by construction much less exposed than the equity index, typically saw drawdowns of 25–35%.

The 2022 bond rout. The more recent, and more surprising, lesson came not from equities but from fixed income. The Bloomberg Global Aggregate Bond Index fell more than 16% over 2022, the deepest annual drawdown in the index’s history. Cautious mandates calibrated on the assumption that fixed income was the defensive ballast were caught by both legs of the seesaw at once: equities falling roughly 18% and bonds falling 16% in the same calendar year.

From drawdown limit to mandate compliance

A drawdown limit in an IPS is not just a number. It is a trigger that should produce a documented response when breached. The Enhance handshake is straightforward: every quarter, Monitor independently calculates the maximum drawdown on every portfolio under monitoring across multiple timeframes, tests the result against the IPS limit set by the trustee, and raises an action point inside Connect if the limit has been exceeded (see Action Points). The trustee then has a structured prompt to open a dialogue with the investment manager, document the response, and either ratify the breach as exceptional or escalate it as a mandate failure.

The discipline matters. A drawdown limit set in the IPS but never tested produces no audit trail. A drawdown limit tested but never producing an action point produces no dialogue. A drawdown limit producing an action point but no documented response produces no defence. Monitor and Connect close all three loops as a matter of routine.

The bottom line

Drawdown is the risk measure you are most often held to account against, by beneficiaries, regulators, auditors and your own boards. It is intuitive, defensible and tangible in a way that volatility and most other risk metrics are not. Setting a deliberate maximum drawdown limit in every IPS, calibrating it to the mandate’s risk profile, and testing it independently every quarter is the simplest and most powerful step you can take to turn investment risk from an abstract concept into something your trust company can govern.

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