Mutual Fund Unlocked: Ulcer Index, another way of measuring investment risk

A lot of bytes and reams of paper have been used to explain the risk in mutual fund investment and various ways of assessing and evaluating them. The most popular being the standard deviation. Although, it is widely used, there are certain drawbacks of this measure of risk that may not entirely capture the pain of an investor. For example, as an investor, you are not worried much if your investment is continuously moving up. Standard deviation does not differentiate between upside and downside movement and treats both in a similar fashion. Moreover, it fails to capture series of losses that result in substantial fall in the investment value.

Ulcer Index developed by Peter G. Martin correctly captures the investor’s pain, which contains more information compared to standard deviation. Ulcer Index addresses the real concerns of investors and measures both the percentage of downfall and for what time such fall sustained from earlier highs.

Ulcer index is calculated as follows for ‘xx’ period.

o Percentage Drawdown = [(Close – ‘xx’ period High Close)/’xx’- period High Close] x 100

o Squared Average = (‘xx’-period Sum of Percentage Drawdown Squared)/’xx’

o Ulcer Index = Square Root of Squared Average

The following graph and explanation picked from his book correctly explain why standard deviation might not be the right metric to calculate risk and investor’s pain. 

• The three hypothetical investments in the chart above have the same annualized return (-0.52%/year) and the same SD (4.66%/month), but no rational investor would consider them as having the same risk.

The longer the period, the better you can judge the performance of the investment. Daily and weekly NAVs will give you a better picture of investor’s stress.  

The way to interpret ulcer index is lower the better and hence if a fund has Ulcer index of zero, the investment would have never lost money. This index should be used to evaluate the performance of different funds in terms of protecting the downside risk. Therefore, if you are a risk aversive investor you should check this index for different funds that you are contemplating to invest in.