Hypothetical Drawdown Analysis Case Study

How would your portfolios or investments react to historical drawdowns if repeated today? In order to answer this question, we decided to explore two case studies, the Great Financial Crisis and the Ebola epidemic using Venn’s Hypothetical Drawdown Analysis feature.

Hypothetical Drawdown Analysis was designed to help allocators understand which historical periods, if repeated today, could create a drawdown in a portfolio or investment given the portfolio’s or investment’s factor exposures. 

Below we dive into two hypothetical drawdowns for the Demo Portfolio ¹ on Venn.

Case Study 1: Great Financial Crisis Hypothetical Drawdown (2007 - 2011)

As the crisis began with the depreciation of the subprime mortgage market in the second half of 2007 ² and the ensuing global financial market crisis in October 2008 (following the bankruptcy of Lehman Brothers in September ³), the Hypothetical Drawdown Analysis would expect the Demo Portfolio to experience a drawdown beginning in October 2007 and ending in March 2009 (a peak-to-trough period of 16 months). 

It took a series of government-led market interventions to stem the drop in asset prices beginning with the passing of the Troubled Asset Relief Program (TARP) in October 2008 ⁴, the reduction of the Federal Funds rate to a target range of  0%-0.25% in December 2008 ⁵, and the American Recovery and Reinvestment Act of 2009 in February ⁶ -- a roughly six month period from the first notable policy intervention to market bottom in March 2009.

Following the hypothetical drawdown period, the analysis would expect the Demo Portfolio to recover over a slightly longer period, rising from March 2009 until April 2011 (a trough-to-peak period of 26 months) to recoup the losses of the drawdown. Below is a summary of the drawdown: the Demo Portfolio’s expected performance is represented by the gold line, and the benchmark’s ⁷ performance is represented by the blue line.

There were notable movements among the factors during the drawdown period (October 31, 2007 - March 9, 2009) ⁸:

• Equity returned -44.15% vs. +3.81% historical average
• Credit returned -17.30% vs. +0.91% historical average
• Momentum returned -4.71% vs. +6.61% historical average
• Low Risk returned -2.84% vs. +9.49% historical average

• Trend Following returned +18.67% vs. +9.60% historical average 
• Quality returned +14.02% vs. +7.80% historical average
• Interest Rates returned +6.79% vs. +3.74% historical average

You can find more detail on factor performance during the Great Financial Crisis and its comparison to the novel coronavirus crisis in our  Comparing Factor Performance During Three Crises eBook.

For the portfolio, the exposure to the Equity factor (beta of 0.54) contributed most to the drawdown, while the exposure to the Interest Rates factor (beta of 0.43) detracted the most, or in other words it helped offset a more severe drawdown. The residual was also a meaningful contributor to the drawdown.

The top two managers (at a combined 26.60% weight) would have contributed to nearly half of the drawdown (48.87%) as they invest in US Large Cap Value Equities and Global Equities respectively. On the other hand, six managers (at a combined 28.72% weight) would have detracted from the drawdown (4.25%). One fund in particular would have helped offset the drawdown the most, with an expected +14.10% return during this period as it invests in Managed Futures.

Case Study 2: Ebola Epidemic Hypothetical Drawdown (2014-2015)

A shorter drawdown would have been expected for the Demo Portfolio as the Ebola virus became an epidemic in 2014. While this outbreak of the virus had its beginnings in 2013 in West Africa, it took until August the following year before the World Health Organization (WHO) declared an International Health Emergency ⁹. In September 2014, Ebola had accelerated into an epidemic, drawing international attention and response ¹⁰. At the same time, there were concerns over slowing global growth and geopolitical tensions such as the ongoing instability in Greece and the conflict between Russia and Ukraine ¹¹. As a result, financial markets proceeded to falter. The VIX opened at 12.32 on September 2nd and reached an intraday high for the year at 31.06 on October 15th ¹², while the S&P 500 dropped 6.8% and the Bloomberg Commodity Index lost 7.6% over the same period.

The Demo Portfolio would have been expected to experience a drawdown from September 1st to October 16th, decreasing by 5%, slightly outperforming the benchmark. The subsequent recovery period would have been expected to occur from October 16, 2014 to February 13, 2015 (a trough-to-peak period of 4 months).

Again there were notable movements among the factors during this drawdown period (September 1, 2014 - October 16, 2014) ¹³:

• Equity returned -7.49% vs. +0.50% historical average
• Credit returned -4.71% vs. +0.12% historical average
• Equity Short Volatility returned -3.47% vs. +0.36% historical average
• Commodities returned -3.40% vs. -0.22% historical average
• Value returned  -1.92% vs. +0.50% historical average

• Fixed Income Carry returned +2.39% vs. +0.32% historical average
• Low Risk returned +2.32% vs. +1.20% historical average
• Emerging Markets returned +1.86% vs. -0.27% historical average
• Quality returned +1.57% vs. +0.99% historical average  
• Interest Rates returned +0.78% vs. +0.48% historical average
  

For the portfolio, the exposure to the Equity factor (beta of 0.54) contributed most to the drawdown, while exposure to the Interest Rates factor (beta of 0.43) and exposure to the Low Risk factor (beta of 0.11) detracted the most, or in other words they helped offset a more severe drawdown. 

The top three managers (at a combined 33% weight) would have contributed to more than half of the drawdown (approximately 56%). Only one manager would have detracted from the drawdown as it invests in cash and other short term bond instruments -- most traditional asset classes fell during this period.

REFERENCES

¹Demo Portfolio approximate allocation: 35% Equity; 32% Cash & Fixed Income; 33% Liquid Alternatives.

²https://www.federalreservehistory.org/essays/subprime_mortgage_crisis

³https://www.nytimes.com/2008/09/15/business/15lehman.html

⁴https://www.treasury.gov/initiatives/financial-stability/about-tarp/Pages/default.aspx

⁵https://www.federalreserve.gov/monetarypolicy/fomcminutes20081216.htm

⁶https://www.ntia.doc.gov/page/2011/american-recovery-and-reinvestment-act-2009

⁷The benchmark is 60% MSCI ACWI Index and 40% Bloomberg Barclays US Aggregate Index.

⁸This historical average is calculated using Venn’s factor returns from 1995 to date. For drawdown periods less than one year, the historical average factor return is scaled to correspond to the same length of time as the drawdown. For drawdown periods over a year, both factor returns during the drawdown and historical average factor returns are shown as 1-year annualized metrics. The historical average factor return will represent the annualized factor return from 1995 to date.

⁹https://www.who.int/mediacentre/news/statements/2014/ebola-20140808/en/

¹⁰ https://www.cdc.gov/vhf/ebola/history/2014-2016-outbreak/index.html?CDC_AA_refVal=https%3A%2F%2Fwww.cdc.gov%2Fvhf%2Febola%2Foutbreaks%2F2014-west-africa%2Findex.html

¹¹ https://www.institutionalinvestor.com/article/b14zbgzx26c6jn/the-4-major-geopolitical-challenges-investors-must-face

¹² VIX Index Historical Data

¹³ This historical average is calculated using Venn’s factor returns from 1995 to date. For drawdown periods less than one year, the historical average factor return is scaled to correspond to the same length of time as the drawdown. For drawdown periods over a year, both factor returns during the drawdown and historical average factor returns are shown as 1-year annualized metrics. The historical average factor return will represent the annualized factor return from 1995 to date.

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