Maximum Drawdown as Predictor of Mutual Fund Performance and Flows

Abstract

Mutual funds’ maximum drawdowns are persistent, indicative of manager skill, and predictive of subsequent performance. Among funds with relatively strong past performance, those with relatively low past maximum drawdowns, on average, have an out of sample alpha of 2.40% per year. That alpha is magnified when markets are turbulent—a time during which manager skill should be most valuable. Investors are averse to drawdown risk. After controlling for typical measures of past performance, fund flows remain a decreasing function of maximum drawdowns, particularly among investors with greater risk aversion and during times of heightened risk aversion.

Keywords: Mutual Fund, Drawdown, Alpha, Skill, Flow