All investments come with a degree of risk, and having a way to measure that risk is an important part of making a sound investment decision. That's why many investors find the Calmar ratio so useful. The Calmar ratio is a formula used to measure a hedge fund's performance relative to its risk. It's calculated by taking a hedge fund's average annual rate of return, typically over a three-year period, and dividing it by the fund's maximum drawdown.

Return And Risk On A Scale

IMAGE SOURCE: GETTY IMAGES.

Annual rate of return

The annual rate of return indicates how a hedge fund has performed over the course of a year. It shows the extent to which a fund's portfolio has gained or lost value, as expressed as a percentage.

Maximum drawdown

Maximum drawdown, as it relates to a hedge fund, is a measure of the fund's maximum loss from its peak value. It is calculated by subtracting the fund's lowest value from its peak value, and then dividing that figure by the peak value.

Let's say a fund's portfolio starts out being worth $100,000. It then increases to $200,000, drops to $90,000, increases to $150,000, and then drops down to $80,000 before eventually climbing back up to $200,000. In this case the maximum drawdown would be 60%, calculated as follows:

($200,000-$80,000)/$200,000 = 60%

Calculating the Calmar ratio

To arrive at a fund's Calmar ratio, we take its average annual rate of return over the past three years and divide it by the fund's maximum drawdown over that same time period. So if a fund's average annual rate of return is 50% and its maximum drawdown is 25%, its Calmar ratio is 2.

Uses of the Calmar ratio

The Calmar ratio measures a fund's performance on a risk-adjusted basis. A higher Calmar ratio indicates that a fund's return has not been at risk of large drawdowns. A lower Calmar ratio, on the other hand, suggests that the drawdown risk is higher.

The Calmar ratio is an important tool when comparing the return of two different funds. Let's say Fund A has an average annual rate of return of 40%, and Fund B has an average annual rate of return of 50%. As an investor, you might be inclined to automatically go with Fund B, since it's average annual rate of return is higher. However, if Fund A's Calmar ratio is higher, you may be better off choosing Fund A over Fund B. The reason? Though Fund B has a better return than Fund A, a lower Calmar ratio means that Fund B may be a riskier prospect.

In other words, if you invest in Fund B, you might stand to gain more than if you were to invest in Fund A. However, you also stand to lose more. The purpose of the Calmar ratio is to illustrate the level of risk taken to achieve a return. Different investors have varying tolerances for risk, but the Calmar ratio can help you align your appetite for risk with the investment choices you're presented with. 

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com . Thanks -- and Fool on!

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.