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Avoiding The Big Drawdown: Is Downside Protection Helpful Or Heresy?

Avoiding The Big Drawdown: Is Downside Protection Helpful Or Heresy? by Wesley R. Gray, Ph.D., Alpha Architect, Author of Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors.

Chasing the Investing Unicorn: Give me “High Returns with Limited Risk”

Having your cake and eating it too is a great way to go. It’s great to have the cake, and it’s also great to eat the cake. But you can’t have it both ways. This trend continues when we speak with fellow investors: “Give me high, after-tax, net of fee returns, but with limited risk and volatility.” Now, we certainly love high returns with low risk. We also love high reward with low effort and high calories with low weight gain. Unfortunately, this brings us to our first problem with the investing unicorn:

Problem #1: Unicorns don’t exist, and neither do high returns with low risk.

Unless you are my youngest daughter, age 3, unicorns don’t exist. Sadly, high return assets with low risk profiles don’t exist either. Assets that earn high returns, such as equities (e.g., an S&P 500 index fund), come with a lot of risk (i.e., you can lose over half your wealth). The only way to earn high returns, but limit the risk, is to develop a timing methodology that identifies how to sell the high-returning asset before it decides to jump off a fiscal cliff. Which brings me to another kink in the high reward, low risk paradox:

Problem #2: Market-timing is extremely difficult.

Let’s start this conversation with a concise summary of a 55 page academic analysis of a variety of systems that claim to have perfect market-timing ability:

Trying to perfectly time the market is a waste of time.

There you go. You no longer need to read this classic academic paper in which Ivo Welch and Amit Goyal assess market timing variables.

Our own research over several years confirms this sad reality. We’ve reviewed hundreds of different concepts and the results are not promising. Most signals never “survive” intense empirical scrutiny and we are generally skeptical of ANY system that purports to work all the time.

Simply stated: nothing works ALL the time.

If unicorns don’t exist (high returns, low risk), is there any good news?

There is a glimmer of light at the end of this investing tunnel. Specifically, academic research indicates that investors who can stomach short-term volatility, avoid benchmark comparison, and follow a model, can systematically outperform over long periods of time. We find the same conclusion with what we call “downside protection.”

Historically, two elements provide downside protection:

  1. Focus on Strong Absolute Performance
  2. Focus on Strong Trending Performance

Of course, past performance is certainly no guarantee of future performance; nonetheless, historically, these methodologies have worked. They haven’t eliminated short-term volatility and one can be sure they will underperform a buy & hold index at some point; however, they have protected portfolios from the most extreme loss situations.

Let’s explore a simple downside protection tool and what the evidence to date can show us.

Rule 1: If weak absolute performance appears, go to cash.

In the illustration below, the white line represents an asset class with poor absolute performance. In general, avoid assets with poor absolute performance.

Rule 2: If weak trending performance appears, go to cash.

In the illustration below, the purple line represents a long-term trend line (e.g., a moving average) and the white series represents real-time prices. The red circle highlights a point where the real time price falls below long-term average. In general, avoid assets with poor trending performance.

Do these simple tools work? Let’s look at the data.

Moskowitz, Ooi, and Pedersen, in a formal academic paper, highlight that technical rules don’t work all the time, but they have been effective at providing downside protection, historically:

“We document significant ‘‘time series momentum’’ in equity index, currency, commodity, and bond futures for each of the 58 liquid instruments we consider…

…A diversified portfolio of time series momentum strategies across all asset classes delivers substantial abnormal returns with little exposure to standard asset pricing factors and performs best during extreme markets.”

Moskowitz, Ooi, and Pedersen (2012)

While market timing systems that work 100% of the time are impossible, we see that some systems, if followed over long periods, can work over time. It all gets back to model discipline and exploiting the behavioral biases of the market (something we love).

Let’s simplify the complex analysis presented in formal academic research and focus on replicating these 2 simple rules. Let’s call our system, the “Downside Protection Model”:

The Downside Protection Model (DPM) follows two simple rules:

  • Time Series Momentum Rules (TMOM)
  • Simple Moving Average Rules (MA)

Let’s review the details of our simple rules:

  • Absolute Performance Rule: Time Series Momentum Rule (TMOM)
    • Excess return = total return over past 12 months less return of T-Bills
    • If Excess return >0, go long risky assets. Otherwise, go long alternative assets (T-Bills)
  • Trending Performance Rule: Simple Moving Average Rule (MA)
    • Moving Average (12) = average 12 month prices
    • If Current Price – Moving Average (12) > 0, go long risky assets. Otherwise, go long alternative assets (T-Bills).

We need a way to combine these two principles in a simple way. We find that complexity does not add value and simple models beat experts. We extend this belief to downside protection by keeping it simple: We create a Downside Protection Model (DPM) rule, which is 50 percent Absolute Performance (TMOM) and 50 percent Trending Performance (MA):

DPM Rule: 50% TMOM, 50% MA