ETF Complete Strategy Insights: Drawdowns (Part 3)

James Kimball | September 15, 2019

The ETF Complete model closed the week down -0.9% compared to the SPY which closed up +1.0%.

The SPY had a decent week, briefly putting in a intra-day all-time high on Thursday, though not on a closing basis. While some of the storm clouds related to trade have started to thin out, the issue remains a key one for markets moving forward.

Stay tuned for the daily updates and log into the website to see holdings and additional performance data.

image

This Week's Strategy Lesson: Drawdowns (Part 3)

image

This week we will wrap up this series on drawdowns.

Drawdown: Quick Review

A drawdown occurs when your equity goes from putting in a new high to moving off of those highs. Ultimately, we cannot know what the maximum of any drawdown is until the equity proceeds to put in a brand new high. It can be very helpful to look at an illustration.

image

In the example above, the equity puts in a new “peak” high at $1,200 in July. Over the next couple of months, the equity sells off down to about $1,050. This happens to be the lowest it sells off to before it puts in a new high a year later, but we cannot declare that low as the maximum “peak-to-trough” drawdown until we see it put in that new high. The time to recovery is simply the length of time between when the equity puts in a peak high and then finally puts in a new high.

The frequency and severity of drawdowns can play a big role in how hard or easy it is to stick with a trading system. Frequent, deep drawdowns can test your resolve to stick with a longer-run winning system. Expectations also play a roll. If you go into a trade expecting a particular or high level of volatility, you can risk and position-size accordingly and stay with the plan.

Largest Historical Drawdowns

The SPY and ETF model data goes back to 2007. This includes the 2008 financial crisis (which shows up in SPY’s largest drawdown). Many the ETF models had their largest drawdown in 2015 from a combination of a steep sudden market decline and a mini flash crash that disrupted normal market processes.

image

The drawdown characteristics of the ETF models are in-line with expectations. The Sector Conservative has the lowest of the sector models while the aggressive has the highest. The ETF Complete, with its added diversification, had some of the lowest drawdowns.

image

The chart above takes the largest drawdown for each model and compares it to the average annual return. Higher ratios here are better in terms of drawdown risk-adjusted returns. Ultimately it is about these types of trade-offs. What we would prefer is stellar performance with no drawdowns, but no system like that has ever been developed or endured multiple market cycles. What we have is a set of models that fit on different points of the risk/return curve. Drawdowns are only one factor in measuring the risk and performance characteristics of a model.