Drawdown analysis is one of the most critical visuals and statistics you can ask for from your asset manager. It’s like asking her (him) to show you how bad the performance of an active strategy can get. The longer the history, the deeper the insight into a fund, a strategy, a model, or an equity curve. A drawdown analysis is not just a visual, it is evidence of a true performance when everything is headed down. Generally, when markets are down, nobody wants to talk about negativity. There is an unspoken rule, when things are bad, nothing much can be done. This is precisely the reason why you should be asking for the evidence. When things were bad, was there a glimmer of better design, a better construction, or was it simply the path to correlated convergence?
For us at AlphaBlock, life begins with a drawdown. It’s the drawdown that makes our Smart Beta Portfolios stand out. It’s the drawdown that talks about our superior design. It’s the drawdown, which gives an insight into why there is alpha to be made.
The image below is the comparison between our U.S. 500 portfolio vs. the S&P 500. Yes, both these baskets have a similar character. What makes one different from the other are the weights. Unlike the S&P 500, which is market capitalized weighted, our U.S. 500 has a different weighing mechanism. Market capitalization means the bigger the size, the bigger the weight. Intelligence is not about skewing the weight more than a market capitalized weightage mechanism, it is about skewing the weight less but still delivering risk-weighted alpha.
As you can see that whenever the baskets drop more than 10% in a week, the portfolio leaves the zero line and starts fluctuating like the coral under the sea. The zero line is the line of no drawdown. If the line sticks at zero, it means that the basket continues to hold on to its intermediate highs and potentially continues to make higher highs. When the basket lets go of the zero line, there can be long recessions (or recovery periods).
I know it may be hard to think about recessions, but as you can see, in 20 years, there have been frequent periods of valleys and dips. The largest one for the S&P500 was from February 1, 2001, till October 1, 2007, a total period of 2433 days. The drawdown chart elucidates this not-so-discussed fact. The S&P 500 had two periods of more than 2000 days, where all the S&P 500 did was recover back to the surface to breathe and then go back for a deep dive. For the Millennials and Generation Z, all these facts might be a lesson in history that things don’t go always go up, there are deep dive periods where wealth remains net negative.
This is where the interesting part begins. A test of an algorithmic process is never half-hearted, it is wholehearted. This is why true algorithms don’t shy away from an apples-to-apples comparison. In this case, our homegrown U.S. 500 is designed as a low-tracking error product, with low turnover and similar risk. Our flagship product (which we are in the process of christening), unlike its peer, the benchmark, had relatively smaller dips. There were no 2000 plus day periods. The portfolio hugged the zero line more than the S&P 500 and the average dip was less than half the size, at 315 days compared to 785 days for the benchmark. This means that our Smart Beta portfolio recovered twice as fast compared to the S&P500.
Now, if you don’t see such a drawdown analysis, and don’t receive a generous explanation and codebase in a sandbox from your asset manager, you have the right to ask for it.”# No Alpha No Pay” is not the upset trucker’s protest in Ottawa, it’s bigger than that. You have the right to ask about alpha because you are paying for it. And if there is no convincing explanation, you can start the revolution by asking for a drawdown analysis.
#NoAlphaNoPay #drawdown
Disclaimer: Past performance is no guarantee of future results. All results shown are based on simulated performance and are without fees and expenses typical of managed accounts which would reduce performance. Nothing contained in this material is intended to constitute legal, tax, securities, financial or investment advice, nor an opinion regarding the appropriateness of any investment. No part of this material may be duplicated in any form and/or redistributed without prior written consent. In so far as this report includes current or historical information, it is believed to be reliable, although its accuracy and completeness cannot be guaranteed. AlphaBlock, Canada specializes in Quantitative and Artificial Intelligence solutions for the financial services and other sectors.