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.

Deconstructing Risk and the Magic 8-ball

Until the broad proliferation of exchange-traded funds (ETFs) it was difficult to find a low-cost option for investing in international markets. Now, not only do we have numerous options in this space and others, but there are reasonable choices for investing in segments of many markets that may provide more efficiency than a position in the broad market itself.

Disclaimer (of course)
I am not a registered investment adviser, nor do I play one on TV. No information contained in The Blog of the Flying Taco on this site is intended to be a recommendation to buy or sell securities of any kind.

Developed International Markets
Whenever I hear someone suggest an allocation to the EAFE (the Morgan Stanley Capital Indices Europe, Australasia and Far East Index; all information © 2009 MSCI Barra. All Rights Reserved), I cringe. Why? Well, let’s look at the last 10 years ending June 30, 2009. On a US dollar basis, with dividends reinvested, the EAFE has clocked in an annual return of a whopping 1.59 percent. Not exactly blowing your doors off, eh? Hell, that’s not even keeping up with inflation! Looking at the variability of monthly returns, you’ll find that the annualized standard deviation of the EAFE during that span is 17.73 percent. Worse yet, if we estimate the 10-year annualized risk-free return to be 3.26 percent, the EAFE hasn’t even beat the risk-free return and tallies up a less-than-impressive Sharpe ratio [(asset return – risk-free return)/asset standard deviation] of MINUS 0.094. The Sharpe ratio is a “bang for the buck” measure of how well you’re compensated for a given level of risk. Numbers south of zilch in this department aren’t exactly what we’re looking for. At face value, if you bought the EAFE at the end of June 1999 you’d have been better served by rolling T-bills. You’d be only a little better off than if you’d stuck your loot in a mattress.

Widely-followed domestic stock indices
The EAFE isn’t alone. The venerable S&P 500 (Standard & Poor’s 500 Index; all information Copyright © 2009 by Standard & Poor's Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved.) LOST an annualized 2.22 percent with an annualized standard deviation of 16.06 percent, for a less-than-stellar-to-say-the-least Sharpe ratio of -0.204. Widely regarded as THE benchmark for American equity investors, the S&P 500 has been worse-than-dead money for the last 10 years…ouch! Its middle brother, the S&P 400 index of mid-cap stocks, has done better over this time period, generating an annual return of 4.61 percent with an annualized standard deviation of 18.32 percent, leading to a positive Sharpe ratio of 0.074. The baby of the family, the S&P 600 index of small-cap stocks, had a slightly higher return of 4.74 percent, but with higher risk - annualized standard deviation of 20.00 percent on the nose – its Sharpe is just about identical to the 400’s at 0.074.

What HAS worked?
I’m not trying to pile on by any means; the last 10 years have been challenging for the equity markets since they included not one, but two difficult periods: the 2001-2003 recession and the global deleveraging that started in 2007 and is still in progress. Still, there have been mildly successful investment strategies in hindsight. Let’s start with the easy one first…a domestic balanced portfolio. Allocate 65 percent to an S&P 400 index fund and the remaining 35 percent to an intermediate-duration US Treasuries fund. If you rebalanced back to the original 65-35 split each quarter (ignoring transaction costs and fund expenses), where would that leave us? We end up with an annualized return of 6.13 percent with a much lower standard deviation of 11.52 percent and a Sharpe of 0.249. Not setting the world on fire by any means, but at least there’s moderate compensation for risk.

The trusty Magic 8-ball
I ran my asset allocation model to determine, in hindsight, what would have been the ideal portfolio to generate real risk-adjusted returns for the past 10 years if we had the investment choices we have today. The model includes 86 different investment options. For this exercise I’ve measured risk tolerance simply based on my age - just over 40 at June 30, 2009. To keep it relatively simple I won’t include local currency investments, because for the individual investor that would entail buying a single-country or region ETF and shorting a currency ETF against it – this isn’t always achievable or even allowable. If you started with the original allocation and let it run for 10 years, you’d end up with a return of 8.86 percent net of fund expenses (at current levels), a standard deviation of 7.67 percent and a Sharpe ratio of 0.731. If we rebalance this allocation quarterly (again ignoring transaction costs but including the current level of fund expenses for each option), we’d generate an annualized return of 9.11 percent with an annualized standard deviation of only 5.30 percent. Our Sharpe ratio on this magic 8-ball portfolio is a tidy 1.165! So what kind of stuff, you may ask, would generate such results? Here goes…

Investment (Allocation percentage)
Intermediate US Treasuries (78.93%)
Chile (9.27)
Latin America (2.95)
Nickel (2.48)
Copper (1.84)
Emerging Europe (1.67)
China (0.78)
Brazil (0.73)
Precious Metals (0.70)
Sugar (0.65)

So there you have it…the bulk of the portfolio is allocated to an intermediate duration US Treasuries fund…a whopping 79 percent! Of the rest, 15 percent is in emerging markets equities (including 13 percent in Latin America), and 6 percent goes to commodities. Now look at what ISN’T there…you guessed it…absolutely ZERO domestic equities. What else is missing? You don’t see any broad market indices here…no S&P 500, Barclays Aggregate Bond Index or MSCI EAFE or MSCI Emerging Markets indices. We’ve deconstructed the risk in these and other larger indices to select smaller segments that fit well together to provide decent, risk-adjusted real returns. Some of these investments on a stand-alone basis exhibit extreme risk characteristics, but when assembled as part of a portfolio of complementary assets we can diversify a significant portion of that risk away.

WARNING! Ummm…we don’t have a trusty Magic 8-ball
That’s right, you don’t. Y’know what? I don’t either. It may be easy to say “well, that weird portfolio of Treasuries, Latin America and commodities worked in the past, so I’ll just do that in the future.” What words do you see in literature and advertisements for just about every mutual fund and investment product?

Past performance is not a guarantee of future performance.

This is so true it’s not funny. The model portfolio above tells us what we should have done ten years ago, not what will work for the next ten years. Besides, I’ve backtested my optimization model to see if what worked in the past several years will work in the future. Guess what…it doesn’t! So what’s an innovative individual investor to do?

Is there an easy way out? Not really…
Say you do a version of the plain-vanilla portfolio I mentioned above – split between domestic equities and domestic fixed income. It’s easy, it’s regarded by a lot of people as “safe” and won’t get you dirty looks at any cocktail parties. Will it work? That’s debatable. Looking at ten years of information, the results over that time aren’t horrible, but consider the strategy’s largest drop from a previous high – the “max drawdown.” This point would have you in the hole to the tune of 31.80 percent after February 2009 from a previous high set in May 2008 – only 9 months earlier. Almost a third of your portfolio…that’ll leave a mark! The “magic 8-ball” portfolio’s hole was much shallower with a max drawdown of 12.42 percent in October 2008 from a March 2008 high – but that’s with 20-20 vision in your rear-view mirror. Easier to stomach, but since it’s in hindsight, it’s not an investable portfolio. Like Marc McGwire, “I’m not here to talk about the past; I’m here to talk about the future.”

...but there's a glimmer of hope
I mentioned that I backtested the “Magic 8-ball” portfolio to see it would work in future periods, and it didn’t work out too terribly well. So it was back to the drawing board. All that historical information has to be good for SOMETHING, doesn’t it? Well, it turns out…maybe. I’ve never considered myself a momentum investor by any means, but I looked at correlations between performance of shorter historical time periods and the following three months of performance. None of them are huge by any means, but I’ve seen a few things that may be interesting enough to discuss once I determine how best to temper the risk profile of the model portfolio.

Leave no stone (or its pebbles) unturned...the sum of the parts is greater than the whole
I’ll be honest; I’m a weird investor. If I can figure out a mathematically sound model for investing, I will be less likely to care about what the portfolio will look like to other people because I can justify it with the numbers. I can sleep at night knowing I've done my all to generate the best risk-adjusted real returns I can. That’s not how everyone works. There are political, currency and other risks associated with many segments of the investable markets. China GDP growth slows and the copper and nickel markets end up tanking, for example. Additionally, some of the investment options trade less frequently than others, so the bid-ask spreads may be wider (adding to de facto transaction costs). A lot of these risks are too much to handle for many investors. The key is to keep your mind open and be honest with yourself about the type and level of risks you’re willing to take. Then be sure to explore ALL available options within your comfort zone and investable segments of larger options. For me, it’s easy to tailor a model to include as many or as few choices as possible from the investment options that I track. By deconstructing the risk of larger indices into their smaller investable components, you’ll often find that the sum of these smaller parts can indeed be greater than the whole.