Understanding the Risk and Drawdowns in Your Investments

It's simply not reasonable to expect that any investment (regardless of type) will increase in value perpetually without having periods of decline. When these periods of decline (losses) occur, your investment is experiencing a "drawdown".  Drawdowns are a normal part of most investments. Evaluation of drawdowns should be conducted with all types of investments. Recovery Risk is the uncertainty of whether an investment will recover from losses and, to a lesser degree, how long the recovery will take. Do stock and stock mutual funds have more or less risk than you think ?

An investment portfolio is comprised of many different types of investments. You may own stocks, bonds, real estate or have Managed Commodity Futures investments. How do you place each type of investment on a level playing field to evaluate its performance?  One way to evaluate different types of investments is to measure the degree of risk exposure ("drawdowns") as compared to the upside potential of the investment.

Drawdowns are a normal part of any speculative investment. It’s simply not reasonable to expect that any investment (regardless of type) will increase in value perpetually (without having period of decline). When performance is down, those periods are known as drawdowns. Evaluation of drawdowns should be conducted with all types of investments.

A drawdown is a decrease or “loss” (usually expressed as a percentage) in total capital, prior to a recovery in earnings performance. Let’s say you buy a house for $400,000. Shortly after the purchase, the market for personal homes softens and the value of your home drops to $325,000. That’s a drawdown of 18.75%. After a while, the housing market bottoms and the value of your home rises from your initial purchase price of $400,000. to $450,000. That would be an increase in the value of your home of 12.5%. After all is said and done, you have actually assumed a “drawdown risk” of 18.75% for the opportunity to earn 12.5%.

Now let us look at another example.  Assume you purchase stock in Widgets-Are-Us at $10 a share. The stock declines in value from $10 per share to $ 7 per share. This is a drawdown of 30%. The stock bottoms and rallies to $12 per share. In this case, you assumed the risk for a 30% drawdown for the opportunity to earn an eventual profit of 20%. Is it a sound risk / reward strategy to make an investment risking 30% to make 20%?

By carefully examining the depth of drawdowns (in any investment), you can evaluate what past level of drawdown risk has been required to potentially earn the post-recovery profit.  Having that information, you can then decide if the risk you must take, compared to the potential reward you may earn, is within your particular “comfort zone”.   Is there a “right” comfort zone.  Not really…The “right” comfort zone is what’s right for you (based on your investment objectives, your tolerance for risk, and your overall investment temperament).  

In Managed Commodity Futures, the drawdown periods for CTA's are documented and disclosed. One of the requirements of CTA's is that they provide their clients (and prospective clients) with disclosure information regarding their prior periods of drawdowns. As you evaluate a CTA's performance, you will see the worst drawdown for a specified period of time. This is simply the largest decrease (expressed as a percentage) in client equity, prior to recovery. How can you evaluate the relative success of a CTA? A more successful CTA will have drawdowns that are (on a percentage basis) “in line” with the profits the CTA earns during periods of successful trading. Additionally, as you evaluate the performance of more successful CTAs you will observe that the CTA was able to stop the drawdown eventually return the program to profitability.   It’s also important to note that drawdowns must not reach a level where the loss of capital makes it too difficult for the account to recover. In short, a more successful CTA's performance record should document that periods of positive performance are greater and longer in duration than times of drawdown. 

As you consider what type of investments are best for you and your portfolio, we encourage you to keep three things in mind regarding drawdowns:

1.    Drawdowns can and do occur in virtually every type of investment (whether it’s the stock market, real estate, managed futures investments, etc.). Even when the long term performance trend for an investment is UP, periods of negative performance (drawdowns) will occur from time-to-time.

 2.   General perceptions about different types of investments may not always prove accurate.  Although many investors view the stock market as a less risky place to invest (less risky than futures investments), there may be times when that’s simply not the case.

3.    Since drawdowns are present in practically all types of investments, the long term success of an investment often hinges on how well that investment RECOVERS from drawdowns (the depth of the drawdown, the duration of the drawdown and the amount of time it takes to fully recover from the drawdown). 

How Deep Can Drawdowns Go? - Now let us take a look at the stock market and the drawdown it had from the year 2000 until the present.

As noted previously, drawdowns occur in every type of investment. That’s true even with the most renown investment vehicle in the world – the U. S. stock market.

Above is a graph that demonstrates just how deep a stock market drawdown can go.  The bars on the graph plots the quarterly value of the S & P 500 cash index.  As you can see, the index reached its high at 1552.87 (during the first quarter of 2000).  From that top, the index began a two-year drawdown.  The low of the drawdown finally came in the fourth quarter of 2002 at 768.63.  From the “peak” (the top set in early 2000) of the drawdown to its “valley” (the bottom set in late 2002), the S & P cash index suffered a 50.50% drawdown.  The depth of this drawdown is, by any measure, quite significant. Furthermore, as of the end of 2005 the S & P has not yet recovered to reach a new high water mark.

Which Has More Drawdown Risk?

As we’ve discussed, many investors believe its far less “risky” to invest in the stock market (buying stocks, investing in mutual funds, etc.) rather than in a futures related program (e.g. a managed futures program).  For many, investing in the stock market is a more “mainstream” thing to do.  To be sure, the leverage inherit in futures trading brings a high degree of risk to this type of investment.  While that’s true, there’s more that must be considered…

Consider for a moment the open losses you would have sustained if you owned an S & P 500 index investment (either an S & P 500 index fund or shares of the SPX that are traded on the NYSE) during the drawdown shown above. The drawdown began in the year 2000 and, when the “valley” was reached 2002, your investment would have lost 50.5% of its value. If you continued to hold the investment until today (more than 5 years later), you would still be waiting for the S & P 500 index to establish a new high.

By comparison, the drawdown in our Futures & Options program began in February 2004 (this was the “peak” level) and the “valley” of the drawdown was set in December of 2004. From its peak to its valley, the drawdown was 33.31%. One year later (in December of 2005, a year after the valley was reached in December of 2004), the program had been able to fully recover all of its losses and establish a new high water mark.

We offer this comparison of both drawdowns to make a singular point – not all common or popular beliefs about regarding investments are entirely true…at least not all of the time. In just about any type of market-based investment, there’s an underlying drawdown risk. That includes the stock market. In some cases, the drawdown risk in the stock market may be quite steep (such as the 50.5% drawdown shown) and may actually be greater than the historical drawdown risk that’s been established in a particular managed futures program. To be sure, managed futures investments hold the risk of substantial loss. As we’ve seen however, the same can likewise be true of a stock market investment.

Drawdown Risk Compared To Potential Reward

It’s a well established axiom that the higher the potential for reward, the higher the level of risk. What’s most important in any investment however is that the level of risk must be proportionate with the potential for reward. Consider this example:

In 1998, Pool Management Services (one of our affiliates) opened a futures fund that was under the trading direction of a third-party trading advisor. In 1999, that fund experienced a drawdown of approximately 41%. Certainly, that was a pretty steep drawdown. However, when evaluating any drawdown it’s critical to view the depth of the drawdown (risk) within the context of the overall trading strategy being employed. The trading program utilized by our fund was characterized by a high degree of volatility (sizable swings in performance). For this particular program, a 41% drawdown was not necessarily out of line. The following year (2000), the trading advisor reversed the drawdown. In that year, the fund was up approximately 258%.

As you can see, a higher level of risk is not necessarily out of line for some investments. The key to the equation is to compare the risk being taken (the potential depth of a drawdown) to the level of potential reward that the investment offers. If you’re going to assume a higher level of risk, there must be a commensurate potential for a high reward.

What’s been the potential for reward in the stock market? During the 1980’s and 1990’s, the S & P 500 performed quite favorably. In fact, the total appreciation of the index during a few of those years exceeded 30%. The average annual return for those twenty years is 15.7%. While the average return during this period was very favorable, there was still a substantial drawdown risk to consider. As noted previously, in just two years (from 2000 to 2002) the index retreated by more than 50%. Does it make sense to own an investment that produced a 15% annual return (with some years up above 30%) while still having a potential drawdown risk of more than 50%? That’s a valid question, and one that many investors fail to ask.

Now consider the drawdown risk and potential reward in our Futures & Options Program. As noted previously, our program experienced a drawdown of 33.31% during 2004. After the drawdown ended however, in 2005 the program produced an annual profit of 57.25% (almost twice the level of the drawdown). Of course, there’s no assurance that profits of this magnitude (or any profits at all) will occur in any year and there is always a substantial risk of loss associated with a managed futures investment.

As noted earlier, we believe that in any investment the level of risk you assume must be in proportion with the potential for reward from that investment. The more favorable the risk vs. reward equation is, the more attractive the investment will be.