Slow burn versus fast burn equity drawdowns - The timing and depth of a decline are both important

 

There has been increased discussion about downside protection strategies during 2022. Why have trend-following done so well in 2022 but poorer during the pandemic crash? Will a put strategy do better during a drawdown?

 

Strategy performance will differ based on the length and depth of any equity drawdown. All equity declines are not alike. If there is a slow grind, the trend-following strategy will do better. If there is a strong quick shock, trend-following may not have enough time to allow for profits to be generated and an option put strategy will be more helpful. 

With an option strategy, the investor must get the size of move and timing right. With a trend strategy, there just must be enough time to generate a signal and a size large enough to generate a successful reversal signal. 

This issue is well-described in the paper by AQR "Should Your Portfolio Protection Work Fast or Slow?" In the last two years equities have had two strong drawdowns - the 2020 pandemic and the 2022 bear market. The sharp drawdown was good for tail-hedge funds while the current bear market has been good for trend funds. 

Strategy selection includes guessing what type of tail event you may face. Predictions are necessary even when trying to protect against uncertain downside events.