SURPRISE!!! Max Drawdown and real returns

Everyone loves to beat their benchmark. It's a huge component of portfolio managers' incentive compensation. If a US small-cap core manager beats the Russell 2000 by 1,000 basis points, you may as well drive the Lexus with the big ol' shiny red bow into his garage for his newly-licensed 16-year-old to drive...

...but what if the Russell 2000 lost 20% this year?

Truer words never spoken than this often-repeated phrase: "You can't eat relative returns."

When I was in public accounting a few years back, I asked a COO from a brokerage client of mine how the year was going. He said, halfway in jest, "we had a better year this year...we only shot off THREE toes..."

Barring extraordinary circumstances, there will be periods where money is lost. Hopefully they are very short and the losses are extremely shallow and quickly recoverable. For investments with measurable track records (most seasoned publicly-traded vehicles or benchmark indices) it's critical to me to examine the investment's maximum drawdown (alluded to in an earlier post, Deconstructing Risk and the Magic 8-Ball)...the largest drop from a previous high...to see how strong my stomach is. If you're looking at something with an annual return over time of 15 percent, it sounds great...until you realize that its max drawdown (no, not Max Headroom - that's an entirely different unfortunate occurrence) clocks in at around 50 percent. Are you willing to stomach the real possibility of a loss of half of your investment in this case? Some are, but many others aren't. As Lou Mannheim, Hal Holbrook's character in Wall Street, said (just as Bud Fox was about 30 seconds away from being carted off to jail):

Man looks into the Abyss, and there's nothin' staring back at him. At that moment, man finds his character, and that's what keeps him out of the Abyss.

Gross vs. net returns

A not-so-little gnome eating away at your egg: Fees and expenses. That 15% gross return may look pretty solid, but if it's attached to 1.5% in fees and expenses, it's not quite as stellar as you think it is. $100,000 compounded at 15% annually over 10 years will leave you with a tidy $404,556. Nicely done. However, factor in the 1.5% and you're left with merely $347,809...which means that over those 10 years you've paid out $56,747 in fees. Keep this in mind. Different asset classes and different markets reward portfolio managers differently for skill. Domestic small-cap and international (especially emerging markets) vehicles tend to carry heavier fees and expenses than domestic large-cap and core fixed income products...generally because these markets are considered to be less efficient and, accordingly, greater rewards are to be gained from execution of an active investment strategy.

Inflation: An even bigger bite than we think?

Thanks to the wealth of data from the Bureau of Labor Statistics, I'm happy to report that as of July 2008, the year-over-year change in the Producer Price Index (PPI) finished goods/commodities segment was close to 10 percent. Even as of September 2009, the year-over-year change in the Consumer Price Index (CPI) Health Care segment was about 3.5 percent. Sure, the core CPI (year-over-year decline of 1.29 percent as of September 2009) garners most of the headlines with the PPI well-reported but in the background. This will be the first year in a long time in which the Social Security Administration does not provide a cost-of-living adjustment (COLA) to pensioners. However, keep an eye out for health care costs; invariably they're rising (the minimum year-over-year change in CPI Health Care was 1.34 percent...as of August 1950). As health care and its associated costs are top of mind to many people, this is a metric worth searching out. Let's go back to over 15% and factor in not only over 1.5% fee/expense amount but our 3.5% inflation metric from health care costs, which will potentially be a significant expense when we're getting older and wanting to reap the benefits of our 15%: That $404,556 you started out with on a gross basis represented a gain of $304,556 on your initial investment. Once fees and a 3.5% inflation bite are taken out, your "real" ending value after 10 years is $243,564, for a $143,564 increase in purchasing power in constant dollars. In truth, fees and inflation have, over the course of 10 years, wiped out over half your gain.

The risk-free rate and Sharpe ratios...and inflation (again)

I like the Sharpe ratio in theory. It measures ratio of the excess return of an investment in comparison to a "risk-free" interest rate (yield on US 91-day Treasury bills is often used) over the volatility of said investment...commonly measured in terms of annualized standard deviation. Roughly and arithmetically, let's say the risk-free rate is 1 percent and we have our investment that generates a 15 percent annual return with an annualized standard deviation of 28 percent. Arithmetically we derive a Sharpe ratio of (15 - 1)/28 = 0.50. For a single-asset, long-only strategy, that may look pretty good in and of itself. However, with short-term Treasury yields well below historic norms and at a de facto rate of zero, how much do they really mean in this context? Personally, I prefer to use an "inflation-adjusted" Sharpe ratio which measures the ratio of return of an investment NET of 1) fees and 2) the GREATER of a) the risk-free rate (I tend to use the gross return on a Treasury money market fund here, since it's more readily investable for an individual investor) or b) an inflation metric of your choosing to said standard deviation. So in the case of the original investment, our back-of-the-napkin calculations would leave us with an adjusted ratio of (15 - 1 - 3.5)/28 of 0.375, which means that for every additional unit of risk, we expect generate 0.375 or 3/8 of a unit increase in purchasing power. What would we call that...the Real Sharpe ratio? The Flying Taco or Taco Loco ratio? Either way, I like it because it provides a measure of REAL compensation for risk. Certain investments fare better than others in inflationary times; this measure does well to capture such a notion.

These are a couple of concepts I touched on earlier but deserve a bit more mention in detail because of the huge potential impact to a portfolio's real purchasing power. Hopefully they can be helpful to others in evaluating investments and constructing a solid portfolio where expenses and surprises are minimized. Let's face it - I don't like surprises, unless it's my birthday, and maybe not even then. Besides, on 364 days out of the year, it's not my birthday. So let's try to make them as surprise-free as we can.

Remember what Bud Fox told his dad when it comes to investing:

There's no nobility in poverty anymore.