In recent years the focus of investment management has shifted away from pure return targeting to constructing a diversified, well-balanced portfolio. As a result, risk management techniques have become increasingly important to the sophisticated investor. There are a number of useful metrics that are used to appraise and monitor performance but one of the most popular that focuses on the downside is called drawdown.
Drawdown measures the cumulative losses from ‘peak-to-trough’ of an asset. Given that all investment decisions include the assessment of historical performance, it can be used to identify what potential short-run losses to expect. In combination with the return expectations of the asset, it can help to contextualise how risky an investment really is. This is important when one considers the investment horizon of an actively managed asset.
If we consider an investment with a two-year term that is expected to generate 5% net gains per annum, would we invest into it if the maximum historical drawdown was in excess of 20%? In this case, timing the market correctly becomes highly important. If we experience a similar level of drawdown, how likely are we to recoup our losses, let alone end with a positive return during the term of our investment?
As an example, we can look at the historical returns of global equities to highlight the importance of drawdown in the context of market timing. Figure 3 [1] shows the rolling two year returns of global equities. There is clearly a significant variation in performance according to when one enters the market. In some instances, returns can be significant and positive, whilst in others deeply negative. However, if we can protect the downside and mitigate the potential for drawdown, then the problem of market timing is reduced significantly.
Some strategies do have return profiles with minimal downside risk. However, due to the well-known risk-return trade-off, these often come at the expense of upside potential. Instead of sacrificing the upside, many investors are considering products that incorporate advanced risk mitigation techniques such as capital protection. Structured appropriately in combination with the right investment strategy, these can provide attractive growth opportunities.
Paravene Capital is a multi-strategy Investment Manager, that marries proven systematic trading strategies with downside protection structures to deliver uncorrelated, stable return streams. To find out more about us please visit our website: https://www.paravenecapital.com/.
[1] The data on global equities is measured by the total return of the MSCI AC World Index between January 2000 and July 2021. The MSCI AC World Index captures large and mid-cap representation across 23 Developed Markets and 27 Emerging Markets countries. With 2,986 constituents, the index covers approximately 85% of the global investable equity opportunity set. Source: MSCI.