by Maz Jadallah

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If you had to choose between experiencing drawdowns and experiencing downside deviations, which would you prefer?   Anyone working in product development in asset management will tell you downside deviations are 10x as bad as drawdowns.

Let’s define each so we’re on the same page.  Drawdowns are declines from peak value – invest $100, it grows to $120 and then your investment value declines to $60. That’s a 50% drawdown (120-60)/120 = 50%

Downside deviations on the other hand are negative deviations from a benchmark. For example, if the market benchmark is down 3% in one year and your fund is down 10%, the downside deviation is -7%.  Similarly, if the market is up 25% and your fund is only up 15%, your fund’s downside deviation is -10%.

Downside deviations are much more painful for investors to stomach than drawdowns because they are relative.  Put another way, as long as “everyone” is feeling the pain (market is down 50%), as bad as that is, an investor will be more likely to handle their own (my fund is down 50%).  On the other hand, if the investor is “one of a few” who are experiencing investment pain (market is up 5% and I’m down 10%), that pain will be 10x as acute.

Avoiding downside deviation is at the heart of how the asset management industry has evolved.  It’s the reason that the vast majority of mutual funds and ETFs are long only their “style” as to minimize tracking error.  It’s the reason advisors (robo and human) are fixated on defining “style” buckets in the first place.  It’s the reason passive investing is so appealing, because for all the investment wisdom in the world, the only way to eliminate the possibility of downside deviation forever, is to simply become the benchmark – even if it means you sometimes get low returns and 50%+ drawdowns. Finally, it’s the reason that a strategy that is designed to potentially suffer a downside deviation is sequestered into the “alternatives” bucket – there is no such thing as a “US large cap growth hedge fund.”

If you think investors hate downside deviation, just spend a few minutes talking to a financial advisor who has experienced a significant downside deviation in a fund they’ve selected. Nothing will precipitate client phone calls quicker at statement time than an investment with a glaring deficiency when compared to its benchmark.

But which is truly more destructive to investor wealth?  You would think that investors would be well served by understanding the trade-offs between drawdowns and downside deviations. The question to explore is straight forward, which is better:

  • Option 1:  Experience downside (and upside) deviations over the course of 10 years but avoid a 50% drawdown, or
  • Option 2:  Experience a 50% drawdown but never experience a downside (or upside) deviation

Table 1 below compares both investment options using the AlphaClone Hedge Fund Downside Hedged Index (Option 1) and the S&P 500 Index (Option 2).  The AlphaClone index’s deviations from the market benchmark (S&P 500) can arise from both its long construction and the fact that it is dynamically hedged.  For a detailed description of the index, please download the index’s guidelines.

Table 1:  Downside Deviations vs Drawdowns

From the perspective of the 10-year investor, ALPHACLN should clearly be preferred with higher annualized returns and about half the drawdown.  Yet in reality most investors would likely choose the S&P 500 simply due to the absence of downside deviation.  While investors in the S&P 500 would have lost half their investment’s value in 2009, as painful as that was, it’s a single event.  In other words, by eliminating deviations, investors in the S&P 500 carry a much lower emotional “load”.

But what if you looked at shorter investment horizons?  After all, despite all the lip service about long term track records, how many investors or financial advisors actually let an underperforming investment’s excellent long term track record override their emotional wiring – very few.  Table 2 below summarizes the results of 60-month investment windows over the 11-year period ended 5.31.2017.

Table 2:  5-Year Investment Windows: ALPHACLN vs S&P 500  (12/31/2006 to 5/31/2017)

Again, investors in ALPHACLN did much better.  Higher average 5-year annualized returns and a 67% win rate over investors in the S&P 500.  The win rate means that investors who chose ALPHACLN outperformed those that chose the S&P 500 twice as often (in 44 of 66 investment windows).  Perhaps even more interesting from the perspective of the investor, is that investors in ALPHACLN never lost money over any of the 5-year windows!  The worst that ALPHACLN investors returned is 3.2% per year over five years.  On the other hand, the worst return for S&P 500 investors was -3% per year over five years.

The analysis above also holds when looking at international equities.  Table 3 summarizes the same 5-year window analysis for the AlphaClone International Downside Hedged Index (also dynamically hedged) as compared to the MSCI All-Country ex-USA Index.

Table 3:  5-Year Investment Windows – ALFIIX vs ACWX

Again, ALFIIX investors did much better than ACWX investors; better average returns, a 80% win rate (!), and never losing principle over any 5 year period.

Despite the evidence that drawdowns have historically been more destructive to investor capital than downside deviations, asset allocators continue to prefer products that minimize the potential of downside deviations, regardless of the consequences.   In the end, investing is emotional and centuries of investor behavior has shown that most investors are more comfortable with strategies that carry lower emotional loads.

It’s been a fool’s errand to argue against investing exclusively in traditional passive strategies.  Since the financial crisis, traditional passive strategies have returned double their historical averages and that’s been a key driver behind the massive dollar flows into ETFs.   None the less, market environments in 2017 are markedly different now with lower overall correlations, less central bank activism around the world and increasing rather than decreasing interest rates.  Double-digit annualized returns for equity market are not sustainable and while 2008 is in the rearview mirror, the world is arguably infinitely more unpredictable today than it was in 2007.   Perhaps that is reason enough to consider a different investment approach.

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