From October, our popular equity mutual fund screener (thousands of our readers use it) will include the Ulcer Index as a parameter along with rolling returns, downside capture, upside capture, trailing returns and standard deviation.
The Ulcer Index is a measure of downside risk in actively managed mutual funds. It is a simple way to find out how stressful it is to hold a fund compared to a benchmark.
The standard deviation (volatility) is a measure of deviations from an average (monthly) return. Both positive and negative deviations are accounted for. The Ulcer Index is defined similarly to standard deviation, but is based on drawdowns (the fall from a peak) instead of deviations from an average.
Suppose the maximum NAV over 2 weeks is Rs. 15 per unit. If the NAV decreases from this maximum, the Ulcer index value increases, indicating an increase in investor stress. If the NAV increases further, the index decreases, reflecting a decrease in stress!
The Ulcer index is designed in such a way that it penalises downside (fall from the maximum) much more than other ratios. Peter Martin and Byron McCann first published it in their book The Investor’s Guide to Fidelity Funds (1989).
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Peter Martin describes the index on his page: tangotools. The out-of-print book in PDF form can be found here.
At that time, pretty much everyone thought stomach ulcers were caused by stress. We later came to know that stomach Ulcers are caused by bacteria – a Nobel prize-winning discovery. Of course, the name Ulcer Index stuck!
- The fall from a peak is computed as a percentage change over 90 days. Although this is much longer than the two weeks recommended by Martin, the extended duration should eliminate noise and be sufficient for the long-term investor.
- This percentage change is known as a drawdown. We square this drawdown.
- We now compute a rolling 90-day drawdown squared and sum all the data.
- The root mean square of this sum is computed and is known as the Ulcer Index. The Wikipedia Page gives more details. This gives the Ulcer Index for a given period.
- Ulcer Score: We compute this Ulcer index on a rolling 90-day basis for each business day for a benchmark and an active MF, and compute how often the Ulcer index of the fund has been lower than that of the benchmark. This is known as the Ulcer Score, also referred to as the rolling 90-day Ulcer index outperformance consistency. We shall use this parameter in our screener.
Now, let us try out the ulcer index with a few mutual funds.
While screening, I recommend checking for high ulcer scores over 5, 7 and 10-year periods.
Take, for example, the ICICI Prudential Large & Mid Cap Fund – Direct Plan – Growth, when compared with the Nifty 200 TRI.
The Ulcer score, as mentioned above, is the rolling 90-day Ulcer index outperformance consistency or how often the Ulcer index of the fund is lower than the benchmark.
| Duration (years) | Ulcer Score |
| 1 | 100% |
| 2 | 97% |
| 3 | 98% |
| 4 | 99% |
| 5 | 89% |
| 6 | 73% |
| 7 | 68% |
| 8 | 67% |
| 9 | 60% |
| 10 | 62% |
That is pretty good downside protection. But how about return performance?
| Duration | Rolling Return Outperformance Consistency Score |
| 1Y | 67% |
| 2Y | 69% |
| 3Y | 69% |
| 4Y | 60% |
| 5Y | 54% |
That is not too shabby, except for over 5 years.
From now on, we recommend that investors first screen for funds with consistently high ulcer scores and then look for strong rolling return performance. Alternatively, our previous recommendation of first looking for consistent downside capture and then rolling return performance still stands.
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