Drawdowns Matter!

One of my biggest knocks on the Securities and Exchange Commission (SEC), which was created to protect investors, is that mutual funds are not required to include Drawdown statistics in fund literature and prospectuses.

What’s a Drawdown? It is the peak-to-trough decline in value of an investment during a Correction or Bear Market.

The SEC mandates that funds provide 1, 3, 5, and 10 year returns in their literature. There is no requirement that drawdowns be reported. Of course, that is pretty much the norm in the financial industry because given enough time, market returns are always positive but drawdowns are always negative. Who in the financial services industry wants to talk about negatives?

Thousands of funds were down 30%-60% during the Late Great Bear. Those same funds are now advertising positive 1/3/5/10 year returns. To find the drawdown, you’ll have to locate a long term chart and manually calculate the drawdown.

My first question when considering an investment is always “what is the drawdown?”. In other words, I insist on knowing what I’m going to risk before I have any interest in hearing about potential rewards. My website lists five reasons to be concerned about drawdowns but I’m going to discuss the two most important.

Drawdowns must be fully recovered before the portfolio can return to growth. Portfolios are binary: on any given day, they are either growing or shrinking. The more a portfolio shrinks, the more it must recover before it can return to growth. If the holes are kept shallow, portfolios spend more time growing and less time recovering. The secret to growing a portfolio (and sleeping well at night) during a full market cycle is finding the lowest drawdowns, not the highest returns.

Investors approaching, or in, retirement may not have the luxury of the time required to recover losses. Bear Markets consume our most precious asset - time. The most recent Bear Market recovered relatively quickly: SPY, the S&P 500 fund, peaked in Oct 2007, hit its low in Feb 2009, and returned to its previous high in April of 2013, a period of 5-½ years following a 51% drawdown. However, the April 2013 high barely exceeded the August 2000 high, a much longer period of 12-⅔ years.

   1972 - 1980 (46%) lasted 7-½ years
   1937 - 1950 (57%) lasted 13-¼ years
   1929 - 1954 (86%) lasted 25 years.

The current extremes in historical market valuations suggest that the next Bear Market will likely require 10-15 years to recover. And the effect of drawdowns will be exacerbated by any withdrawals taken during the period.

Bear Markets share one characteristic across history … they decline quickly and recover slowly. The trick is to minimize the drawdown during the sharp decline. This puts you in a position to ride the recovery for fresh gains. That’s our secret sauce. Our Tactical Asset Allocation strategies are designed to reduce lower risk during declines and improve returns during the recovery.

To summarize, minimize your drawdowns and the returns will take care of themselves. The next time you are tempted by prospective returns, ask to see the Bear Market drawdowns. If there is no Bear Market history, or the drawdowns exceed your comfort level, look elsewhere. You don’t have to look hard on this website, you’ll find historical drawdowns shown right next to our historical returns.

 

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Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

We make extensive use of index funds and most of those have predecessor Open End Funds (OEFs) using the same index,. We use infill from Open End Funds to construct fund "similar" tables for two full market cycles beginning in 2000. In each case where we have used an Open End Fund for infill, we consider the indexing and/or subclass to be substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second cycle, they also offer the advantage of completely out of sample data.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

We make extensive use of index funds and most of those have predecessor Open End Funds (OEFs) using the same index,. We use infill from Open End Funds to construct fund "similar" tables for two full market cycles beginning in 2000. In each case where we have used an Open End Fund for infill, we consider the indexing and/or subclass to be substantially similar to the ETF. Aside from providing insight into possible strategy performance during a second cycle, they also offer the advantage of completely out of sample data.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.

Our standard tables are constructed for one full market cycle beginning in October 2007. The fund baskets for our tactical strategies are constructed from Exchange Traded Funds (ETFs) with just two exceptions, an Open End Fund and a Closed End Fund, both with long history. Fund sponsors did not begin the heavy rollout of Exchange Traded Funds until 2005 - 2006 so prior history is often unavailable.

The Innovation ETFs used in the Innovation Strategy were not established until 2014-2015 so our history is limited. There are no predecessor funds which are similar enough to use for infill.

A Caveat

A 35+ year secular bull market in both equities and bonds began in 1982. The last cyclical bull market in equities (and to a lesser extent, bonds) began 10 years ago. Returns during these periods have been historically exceptional. Market returns for the next 10 years are highly unlikely to approach those of the past 10. In fact, there is at least some evidence that market returns have a high probability of being significantly lower and that bonds and equities (which have risen together) may actually begin working at cross purposes.

Investors should not use the statistics shown for our strategies to establish expectations of specific levels of returns or drawdowns. Investors should, however, appreciate that we believe the principles which underlie the Tactical Adaptive Global, Tactical Adaptive Income, and Tactical Adaptive Innovation Strategies are enduring enough to significantly outperform the market in the future, both in lowering risk and in improving returns.