Ulcer Index 2.6: A Better Risk Measure?

Abstract

This article addresses the growing awareness that the most commonly used risk–reward metrics, such as the Sharpe ratio, are flawed. Including the winning returns as part of the risk and assuming that returns are normally distributed are two of the biggest flaws. These problems, and others, have motivated a search for alternatives. The authors analyze one prominent alternative risk metric, the Ulcer Index (UI). It does what a risk metric should do—measure the depth and duration of drawdowns. One criticism against it, however, is that it fails to adequately reflect the appropriate risk of the most severe drawdowns. One suggested response requires setting a hard boundary for drawdowns, beyond which they are weighted more severely. By contrast, the authors suggest that, even if appropriate, there is a more graceful solution, one that simply raises the power of UI beyond 2.0 to smoothly reflect the greater severity of drawdowns as they increase in size. How much beyond 2.0 is ultimately a decision for fund managers, but they suggest 2.6 as a balanced level that provides greater sensitivity to larger drawdowns without overweighting them—hence, UI 2.6.