The Importance of Managing Drawdown Risk
11/14/2024
Introduction:
At its core, drawdowns are simply a drop in value of an investment from its relative peak to its relative trough. There are periods in history where drawdowns may be somewhat muted based on fleeting exogenous macro forces, localized sector headwinds etc. An example of this might be a market selloff due to election uncertainty or a near-term catalyst such as a Fed rate decision. In other cases, drawdowns may be more pronounced due to systemic shocks which reprice entire sectors or broader markets. Examples of this would be the Great Financial Crisis of 2008 or the swift drop in asset prices in March 2020 due to COVID-19. While these two examples were arguably very difficult to predict for the average investor, the reality is their damaging aftereffects were felt for years, and in some cases, investors did not recover.
Drawdown Case Study:
Since we as a firm are focused on the credit space, we wanted to share a real-life example of how sustained drawdowns can hamper the recovery of even seemingly safer investments. In our example we outline the performance of the broadly tracked Bloomberg USAgg Index (“Agg”, Ticker: LBSTRUU) after the Federal Reserve began its historic rate hiking cycle in 2022. The graph below helps illustrate the frequency and depth of down months that the Agg fixed income index sustained since February 2022. The bars in blue are the monthly returns of the index, and the orange line tracks the compounded cumulative return since chart inception as of each period. To highlight the impact of drawdowns – consider that as of the last period in this chart (October 2024), a dollar invested in the Agg in February 2022 would still be underwater 33 months later. This is long after the market began pricing in cuts and even after the Fed moved forward with its first 50bp rate cut.​​​​​​​​​​​​​​​​​​​​​​​​​
The Agg is one example of an investment that is still suffering since early 2022 but there are many others. In fact, Goldman Sachs recently reported in an August research piece that, despite the impressive gains this year by many funds, a third still have not fully recovered from these 2022 lows. They range from hard real estate assets to funds focused on growth equity, venture capital, fixed income and private equity to name a few. While we view all these asset classes as integral to a balanced portfolio, we do believe it is important to go in eyes wide open.
There are three questions we will keep in mind when doing our next analysis.
1) What is the required return from the drawdown trough to get back to even.
2) Given an assumed market return, how long will it take to recoup losses.
3) At that assumed market return, what would the cumulative return (or loss) be after 5 years of sustained recovery.
For this analysis, we assume the path of recovery is geometric at an 8% per year market return. The chart below helps answer some of the above questions and opens the discussion to other exogenous forces that go beyond the numbers.​
Drawdown A: 5%
This is a relatively muted drawdown which may be short-lived and unlikely to be catastrophic offering an investor a reasonable path to break even. Perhaps a 5% selloff was caused by a short-term disruption to the market or a localized loss within a portfolio position. Maybe the portfolio was overweight in a specific area which has since gone out of favor and the manager ultimately has a chance to rebalance based on new information. Or it’s possible the manager had strong risk controls in place and was able to mitigate losses before they got worse. In any of these cases, the path to get back to even presents itself with a reasonable 5.26% return requirement. While this is not an ideal scenario for lower vol strategies, it is perhaps even expected in certain higher vol strategies where single digit drawdowns are not uncommon.
Drawdown B: -15%
This scenario is more representative of a deeper sell-off which could occur during an extended bear market where a portfolio may sustain bigger losses. In the equity markets, for example, we have seen these types of drawdowns during periods such as 2018 when the Fed first tried to hike rates after a decade of quantitative easing. In that particular example, the drawdown on the S&P500 was closer to 20% and was very clearly driven by concerns of rate hikes and their potential effects on equities. Similar to Drawdown A, an investor may decide that the drop in portfolio value is temporary, and they may not hit the proverbial panic button. While these losses may be palatable in the near term, the manager now must make back 17.65% to recover from its 15% loss. The difficulty in the climb back to high water becomes a bit more apparent as the losses get bigger.
Drawdown C: -30%
We are now approaching a scenario which some investors and managers struggle to recover from. We saw sizeable drawdowns such as these during larger scale macro weakness such as Covid-19. When these large drawdowns occur, investors may begin to re-evaluate the fundamentals of their portfolio and may not have the latitude to "weather the storm" so to speak. They may genuinely question the fundamentals of their investments which could lead to them selling assets. Perhaps even more striking is the path back to recovery. In this scenario, a 30% drawdown would require a manager to return almost 43% to get back to their highwater. Given our recovery assumptions above, the path to just breakeven would take close to 5 years.
Drawdown D: -50%
While this final scenario may seem extreme, it has in fact been a reality for some. The 2008 Great Financial Crisis, for example, saw multiple funds ultimately implode due to extremely large drawdowns such as these. While the strategies varied across equities, real estate, credit etc., the headwinds facing investors and managers were severe. Referring back to our matrix above, a 50% drawdown would essentially require a 100% return from the trough just to break even! At our given 8% assumption, it would take ~9 years for an investor to recoup its losses. Along with this extended time to recover comes opportunity cost and, in some cases, a lack of incentive on the part of managers to wait it out. The reality is some simply decide to shut down rather than fight their way back.
This second chart maps out the path of each of the above scenarios to better illustrate the path to recovery for a given drawdown. As we move to the right where the drawdowns get larger, the Required Return to Break Even (orange line) gets steeper. In addition, the 5-year Cumulative Return (green bars) trends further negative as the drawdowns are more severe. For example, in the 5% Drawdown, the 5-year Cumulative Return is approximately +40% whereas in the 50% Drawdown, the 5-year Cumulative return is still negative at approximately-26%.​
This serves to illustrate that while we may be conditioned to view drawdowns as tertiary events, their effects can be quite long lasting. The examples given were purposely laid out in simple terms, however, the reality is the path is unlikely to be straight forward on the way down or the way back up.
Conclusion:
While drawdown risk is unavoidable, we believe it can be mitigated through rigorous and thoughtful risk management. It isn’t just the return in any given period that matters most, but rather the risks you are taking to get it. Financial market history tends to repeat itself in different forms throughout the years, and we believe those who study it are more likely to weather the next storm. We included real-world and hypothetical examples to illustrate a range of scenarios that serve as good reminders of what the back end of an elevated volatility cycle can look like. While it is difficult to predict if or when the next 2008 GFC, March 2020 or Feb 2022 will present itself, hopefully the lessons learned will better position investors should that time come.
External Links:
Below, we are including a few interesting links to publicly available articles and publications that we found useful. We are in no way taking a view on anything discussed or presented but found them interesting purely for informational purposes.
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A Third of Hedge Funds Have Not Fully Recovered From 2022’s Losses
S&P 500 Total Return Index History
An Introduction to Drawdown Risk
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