Wednesday, May 11, 2016
Drawdowns are everywhere - this is a problem of proportionality
"My golly! I can't hold that managed futures fund, it is always in a darn drawdown." I have heard far worse language in reference to a fund in a drawdown. The logic of the investor is simple. Managed futures funds are bad and risky investments because they are always in drawdowns. I don't like drawdowns. It never fees goods. A drawdown eats into any high water mark and suggests a loss of principal on a mark to market basis.
Interestingly, the focus on drawdowns is a result of the regulatory requirement to report drawdowns. CTA's have to report the largest drawdowns. Mutual funds and normal asset managers do not have to report drawdowns. There is no problem if you don't have to report the problem.
Look at some simple balanced fund structures that should not be considered risky, the classic 60/40 stock/bond mix and a three asset stock/international stock/bond aggregate combination. Each of these funds spent close to 85% of the days in a three and half year period in a drawdown. The drawdowns have exceeded 7 percent in 2016. Granted the max drawdowns were limited given the diversification with combination.
I am not arguing not to use drawdowns as a measure of risk. A levered investment can have significantly greater drawdowns than what is reported above. A drawdown is a problem given it shows a loss of principal and requires returns to regain that principal. What is important is having a sense of scale and proportion. Even a low volatility portfolio will spend most of its time in a drawdown and the size of any drawdown will be a function of volatility.