Understanding investment risk through drawdown analysis

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Understanding investment risk through drawdown analysis

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Understanding investment risk through drawdown analysis A more refined method of managing and mitigating loss Risk is a central theme in the investment world, a counterweight to investor s desire for return. The irony is that, given the enormous role and usage of the term, the concept of risk is typically not well defined and can even be subjective, making risk arithmetic challenging to understand if not outright misleading. Return, on the other hand, is easily defined by the growth or decline in the market value of a portfolio. As detailed below, standard deviation, the broadly used default risk metric, has significant limitations. This leads us to embrace the concept of drawdown as a more intuitive and therefore useful approach to understanding and tracking investment risk. figure 1 Loss potential Standard deviation line 32% of outcomes 68% of outcomes The limitations of standard deviation Standard deviation is a measure that is used to quantify the amount of variation of a set of returns. A low standard deviation indicates that the returns tend to be close to the average (also called the expected value) set of returns, while a high standard deviation indicates that the returns are spread out over a wider range of values. Furthermore, standard deviation is: Influenced by up market results as well as down market results, which can obscure the risks of loss from an investment or portfolio position 32% or nearly 1/3 of all outcomes fall below the standard deviation line Looking at the downside half of a normal distribution, we can see how much of the downside risk is not accounted for by standard deviation Measured on the basis of historic results, which can dramatically influence the story being told The actual truth is that risk in the markets might be exactly the opposite of what the standard deviation measure is telling us. While the 2008 global financial crisis caused catastrophic market upheavals, by 2011, downside risks had been significantly reduced as a result of financial strengthening in the banking industry and the Federal Reserve s diligent efforts to provide safety and liquidity. On the other hand, the market rallies in 2016 while justified by improving earnings and expected page 1 of 5

figure 2 Annualized standard deviation (Last 5 years) 27.1% Year end 2011 12.4% Year end 2016 Since these goals are measured in terms of dollars and time, the use of a drawdown yardstick that is also measured the same way provides investors with a simple means of comparing their future desires and portfolio risks. improvements in the tax and regulatory environment were pushing to stratospheric levels market measures such as price/earnings multiples, where downside potential in the market was likely getting greater. Clearly a better means of providing quantitative risk assessments is needed. Drawdown, a better approach Given these inadequacies, what can we look at as an additional and more intuitive risk measure? The measure that we believe provides a better assessment of security and portfolio risk is drawdown. Drawdown measures the difference in value from the most recent peak to the most recent trough in the market. It can be measured in terms of dollars, which offers several benefits to the modern investor. Traditionally, investors focused on how their results compared to market results to determine if they were satisfied with their investment performance. This methodology was popularized by institutional investors and their investment consultants. While this view continues to have value, individual investors have become more focused on goals-oriented investing as they look to their wealth to help them achieve highly desired or needed outcomes, such as a secure retirement, education funding for family members, etc. Since these goals are measured in terms of dollars and time, the use of a drawdown yardstick that is also measured the same way provides investors with a simple means of comparing their future desires and portfolio risks. The investor can seek to control the drawdown exposure of their portfolio through the asset allocation decisions and selection of investment managers. This can help improve the odds that the investor s portfolio will be able to meet stated goals within stipulated timeframes. Drawdown-based asset allocation Consider the different ways of looking at potential drawdown outcomes. One method is to go back and assess how individual securities or portfolio combinations behaved during pivotal historic events. For example, comparing one s portfolio today to the Asian financial crisis in 1998 (which wreaked havoc on much of Asia and stirred fears of a global meltdown) can give a good measure of how the portfolio might react to a foreign-generated currency crisis. Other significant events can be similarly modeled to provide investors with an understanding of how their portfolio might react to a variety of previously experienced market disruptions. These are typically called stress scenarios. While stress testing (or back testing) your portfolio based on past events is a good way to check how your investments might have performed, we could also be analyzing forward-looking measures, such as valuation metrics that include price/ earnings ratios, dividend yields, and price-to-cash flow, etc. Cheap market conditions from the past are likely to suggest reduced risks of significant future drawdowns, page 2 of 5

If an investor experiences a 20% drop in the value of a portfolio, a return of 25% is necessary simply to get back to the starting point. while higher valuations may very well indicate the opposite taking place. Investors can tailor their risk appetites based on these conditions and their goals-based objectives to help them stay on track to achieve success. Portfolio optimization involves determining a high-quality combination of assets, factoring in return expectations, asset class volatilities, and the correlations of results among various asset classes. Portfolios based on drawdown exposure can be optimized by substituting drawdown for volatility in developing the desired combination of assets for given drawdown levels, a result that creates what is often referred to as the efficient frontier. Optimizing this combination of assets is critical to investment success, since it enables an investor to manage the degree of downside risk in a portfolio. Consider the simple reality that, if an investor experiences a 20% drop in the value of a portfolio, a return of 25% is necessary simply to get back to the starting point. Bigger drops lead to even more lopsided situations: a 50% drop requires a 100% return to get back to square one. Managing drawdown exposures, therefore, becomes critical. Consider Figure 3 on the next page, which shows two hypothetical portfolios that have been constructed based on different treatments of drawdown exposure. The blue line represents the portfolio that has been constructed employing drawdown optimization techniques, while the green line represents a portfolio not optimized for drawdown. Both portfolios start out with a $10 million investment and have similar risk levels. The blue-lined, drawdown-optimized portfolio adds $440,000 in value over the 17 years used to construct the back test. As Figure 3 depicts, a drawdown-optimized portfolio may provide these distinctive benefits: 1. Higher Sharpe ratio (the average return earned in excess of the risk-free rate per unit of volatility or total risk) 2. Lower drawdown and higher overall ending wealth values 3. An under-two-year period in which to regain peak (pre-drawdown) portfolio levels, which is critical, as there could be critical time-sensitive goals a client needs to achieve Avoiding unforced errors Market downdrafts are never comfortable situations. Markets will test the resolve of even the savviest investor. It is at moments like these that managing expectations is critical, as investors can let fear and other emotions get the best of them and be driven to make investment mistakes. The investor who has built a plan around manageable drawdown prospects is in far better shape to weather this storm. Having a reasonable awareness of how much downside there is to one s portfolio may enable page 3 of 5

figure 3 Growth of $10 million (Performance January 2000 May 2017) $25 $20 Drawdown optimized Maximum drawdown: 30.8 $15 $10 $5 Non-drawdown Maximum drawdown: 35.1 2000 2002 2004 2006 2008 2010 2012 2014 2016 Drawdown-optimized portfolio Non-drawdown Initial wealth Drawdown optimized Return: 6.34 Sharpe ratio: 0.75 Ending value: 28.4mm Nondrawdown Return: 5.45 Sharpe ratio: 0.58 Ending value: 24.0mm Value added: $4,400,000 Data shown are for illustrative purposes only, reflecting the historical application of static allocations to index results, and do not reflect the results of actual investing from clients. The Optimized and Baseline Portfolios were created with the benefit of hindsight and do not reflect the impact of material economic or market factors on investment decisions. The Optimized Allocation includes asset classes that do not appear in the Baseline Allocation, reflecting real asset and liquid alternative strategies. Data reflects index returns and are not reduced for the impact of fees, trading costs or any other expenses. Investor returns are reduced by such fees and expenses incurred in the management of an investment account and have a compounded impact over time. Similarly, the returns shown would be lower if the results reflected the deduction of advisory fees. Investing involves risk and you may incur a profit or a loss. Past performance is no guarantee of future results. page 4 of 5

an investor to remain calm during turbulent times and not sell investments at the very time the market may be getting near a bottom. Conclusion: Implementing the drawdown framework Implementing an investment framework that includes drawdown-measuring capabilities is not an easy task. The breadth of uses and computations required stretch from performing simple estimates on individual securities to the far more complex issues that involve estimating future drawdown risks and optimizing performance. To make this a reality, Wilmington Trust has partnered with MSCI to develop a risk platform that aims to galvanize the achievement of investment goals. Wilmington Trust Investment Advisors has added to the core function a drawdown functionality, resulting in our robust investment tool, which enables us to assess clients goals-driven investment objectives and use drawdown risk to build investment plans that strive to meet their needs and comfort levels. To explore how drawdown analysis may help curb risk in your portfolio, contact a Wilmington Trust Relationship Manager. This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. This article is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly owned subsidiary of M&T Bank Corporation. Investment management and fiduciary services are provided by Wilmington Trust Company, operating in Delaware only, and Wilmington Trust, N.A., a national bank. Loans, retail and business deposits, and other personal and business banking services and products are offered by M&T Bank, member FDIC. Investment Products: Are NOT Deposits Are NOT FDIC-Insured Are NOT Insured By Any Federal Government Agency CS15992 11-2017 page 5 of 5