What is Drawdown and why is it Critical to Control It?

Drawdown is an important risk measure for portfolio management. Without explicit loss control mechanisms, traditional passive asset allocation portfolios can experience large drawdowns that take a long time to recover from.


Source: Newfound Financial Innovators
The “drawdown message”:
1)     Even by eliminating the noise, which means ignoring drawdowns of less than 5%, the S&P 500 Index has spent 82.95% of its time (between 1927 and 2012) in a state of drawdown (defined as either in a declining state or climbing out of drawdown and not yet exceeding prior high).
2)     As shown on the chart below, the gain required to recover from a loss is exponential. Drawdowns of 20% or less can be recovered from fairly quickly but letting them get much bigger requires a lot of time to recover. Keeping maximum drawdown to 20% or less for growth-oriented portfolios is a good goal for portfolio managers. More conservative portfolios for clients with lower risk tolerance should have even lower maximum drawdown tolerance.


Source: Crestmont Research
Ways to Control Drawdown:
1)     Strategic allocation of non-correlated investments:
This is by far the most commonly used technique by investment advisors. If properly constructed, this type of portfolio is usually fairly low maintenance - only requiring rebalancing at designated intervals and regular monitoring of investments chosen for each asset class.
This method can be quite effective at controlling the drawdown but its effectiveness is dependent on the non-correlation of each asset class in the portfolio. There have been times that too many asset classes have become very highly correlated and therefore not as effective.
The negative to this approach is that is creates a drag on the portfolio performance when things are going well. It assures mediocre performance when stocks are doing well because it has a constant allocation to assets that are non-correlated and may not be doing well - kind of like have the brake applied all the time so you don’t get in trouble going around a curves and also keeping the brake applied on the straight-aways too.
2)     Purchase Put Options:
This method can be effective at cutting off the “left tail” returns and helping reduce maximum drawdown but it comes at the cost of purchasing the options themselves, which reduces overall return and requires quite a bit of maintenance and working knowledge of options.
3)     Tactical Overlay:
Using a rules-based, tactical overlay to implement an adaptive asset allocation or flexible asset allocation can significantly reduce the left tail returns and reduce maximum drawdown. It can also retain or even enhance the return structure in bullish market conditions.
AlphaRotation tactical ETF portfolios utilize a unique tactical approach to minimize drawdown and retain growth potential.