6 February 2020


By Raul Elizalde

This article also appeared on forbes.com

Maximum drawdown, or how much a security falls from a previous high, is a revealing measure and generally easier to understand than volatility. It simply calculates the loss incurred by those who bought at the worst possible time – i.e. at the top. Investors who want to alter their sector mix in search for higher returns may want to look also at their potential losses if they get the timing wrong.

The U.S. equity market has been riding a record-smashing rally. After sustained runs like this one, investors typically start to tinker with their investments. They buy more of some sectors and less of others, either because they hope to extract a little more juice over the broad index or because they want to protect some of the gains but still participate in the upside.

This can be easily observed in the correlation among sectors. Deep into a rally, correlations tend to fall as people get choosier about what they buy and sell.

One important factor in assessing the risk associated with sector rotation is the extent to which potential losses change when altering the asset mix.

The two most common measures of performance are return and volatility. The first answers a question everyone understands: how much does a security go up or down in a given period?

Most people, however, will be hard-pressed to explain what volatility exactly means. How is a 12% volatility (represented by the standard deviation measure) different from a 16% volatility? This gets even trickier when comparing two investments that have different volatility and different returns.

One way analysts try to get around the return vs. volatility problem is by comparing volatility-adjusted returns. One way is simply to divide return by volatility, to have an idea of the path taken to achieve a certain return. If a 5% return took place with little variation in a given period, it may be preferable to a 7% return gained with lots of ups and downs in between. The quotient merely reflects the return of a security per unit of volatility.

The problem here is that this measure often shows instruments like U.S. Treasury Bills coming up on top, since their modest returns are virtually volatility-free. SHY, for instance, an ETF that tracks a basket of Treasury instruments with maturities of up to 2 years, has vastly better ratios than any stock sector in most circumstances. Few, however, would declare SHY a superior investment.

A useful measure that relates to volatility is maximum historical drawdown, or the most a security has lost from a previous high in the past. This is relevant because investments bought at the top of their range will go on to lose money (by definition) but not all will fall by the same amount. It matters how much, because modest declines are more easily tolerated than deep crashes. This makes it more palatable for investors to stay with the security and participate in any potential recovery that follows.

For example, investors are acutely aware that the technology sector has been the star performer of the last three years. The ETF that tracks it (XLK) had a total return of almost 50% in 2019 alone. But when the market goes down this ETF loses more than the market as a whole. This has been a consistent pattern, unbroken in the last 8 years.

source: Federal Reserve Bank of San Francisco

This is important because the stellar performance of the tech sector is attracting many investors in search of a boost to their portfolios. This is understandable as the 3-year total return of XLK (2017-2019) was a stunning 114%, well above twice the S&P 500. If the market turns around, having additional exposure to XLK is very likely to cause larger-than-market losses.

Investors may want to remember, for example, that the ETF that tracks the energy sector (XLE) had a far more impressive performance in the 2004-2006 period, with a total return of 127%, which was four and a half times the S&P 500. Those were the days where the most in-demand college degree was said to be petroleum engineer, the Colorado School of Mines was the institution that turned out the best-paid graduates, and North Dakota was the golden destination for workers in search of high-paying jobs. The enthusiasm for energy stocks was not unlike today’s enthusiasm for the technology sector.

source: Federal Reserve Bank of San Francisco

When the energy sector fell out of favor, portfolios that had padded their energy sector exposure in search of extra returns experienced deep losses. It turned out that the sector tends to crash much more than the S&P 500: On average, in the last 17 years, XLE has lost twice as much as the S&P 500 from a previous top.

The Financials sector has the dubious distinction of having the worst drawdown in recent bear-market times, and this is because of, well, the financial crisis. But this is not the only reason why this sector is so risky. In every one of the last 17 years it managed to lose more than the S&P 500, making it one of the riskiest U.S. equity sectors from that point of view.

source: Path Financial LLC

Conversely, investors who search for protection against major losses but still want to participate in some of the upside may well consider the ETF that tracks the consumer staples sector (XLP). This was, by far, the best-performing sector during the carnage of 2008 and 2009. Along with the utilities (XLU) and health-care (XLV) sectors, the group is considered “defensive” and for good reason: in the turbulent 2008-2011 years, the S&P 500 declined, on average, close to 3 times more than these sectors.

source: Path Financial LLC

Examining maximum drawdown can give investors an insight on the kind of risk they are exposed to in very practical terms. This can be helpful when deciding the asset mix, as it provides them with a sense of how much downside they may face at any given time, even if they think that the bull market will continue.

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