Well, despite some recent market turmoil from the Brexit, the S&P 500 is still hovering near its high from last year on a price basis. If we include the reinvestment of dividends, then we have already seen new highs in April, May, and June of this year.

As we wrote about previously, a bear market might be the only way to boost the expected returns on U.S. equities. Investor who thought they might be getting one either last summer or early this year were wrong.

Last September, we wrote a post on whether that drawdown from the July high would turn out to be like 2008 or 2011. After a few more months, we had our answer: neither.


Data from Yahoo! Finance. Analysis by Newfound Research.

But then as the new year unfolded, the market turned again before bouncing back in February and March to yield a new answer: 2011.


Data from Yahoo! Finance. Analysis by Newfound Research. Data as of 7/6/2016.

We said in the previous post that market drawdowns tend to unfold over periods much longer than weeks. The end of 2015/beginning of 2016 period was no exception. It was essentially comprised of two 10-week drawdown/recovery cycles – hardly a 2008.

We can look at these two drawdowns individually and see how different they were both from 2008 and 2011 and from each other. Consider the overlay of the period from November 2015 to now. Midway through the period, that drawdown looked even more like 2008 than the drawdown from earlier in 2015, but then it came roaring back much faster.


Data from Yahoo! Finance. Analysis by Newfound Research.

Unfortunately, these quick changes in market direction are not favorable for momentum-based risk management strategies since they increase the cost of whipsaw.

We can see the impact by looking at a simple momentum strategy that invests in the S&P 500 when its 50-day simple moving average (SMA) is above its 200-day SMA and in 0% return cash when its 50-day SMA is below its 200-day SMA. It experiences whipsaw during both of the recent drawdowns.

However, by dollar-cost averaging in the portfolio over the course of a month, the cost of whipsaw is cut by 400 bps over the entire period.


Data from Yahoo! Finance. Analysis by Newfound Research. Data as of 7/6/16.

While, on the surface, this performance still leaves something to be desired for a risk management strategy, a closer look at the limits of tactical equity turns the blame around to our own expectations of tactical. We previously discussed that performance like this does not imply that tactical is broken. Rather, it means that we need to reassert to ourselves the market environments tactical is likely to out/underperform.

Let’s look at how managed futures, another common risk management strategy, performed over the period.


Data from Yahoo! Finance. Analysis by Newfound Research. Data as of 7/6/16.

From this performance, managed futures seemed to be the stellar risk management strategy. But we have to look no further than 2012 and 2013 to find periods where we would have drawn the opposite conclusion.


Data from Yahoo! Finance. Analysis by Newfound Research.

When we talk about risk management, we often evaluate strategies on two fronts: managing the risk of losing money when the market is going down and managing the risk of not making money when the market is going up.

As investors, we acknowledge that there will be a cost for providing the risk management when we need it (e.g. returning -10% when the market loses -35%). This cost is easier to justify when we are looking at larger returns.

Psychologically, we tend to feel more upset when we are down -5% when the market is up 5% versus when we are up 20% and the market is up 30%. The underperformance differential is the same, but the context is different. This is our concave utility function in action (i.e. we are more upset about larger losses).

In an environment where expected equity growth is muted, being thoughtful about how you construct a risk management strategy is essential. There are few steps we can take to manage risk in our risk management strategies:

  1. Ensure that you are aware of the market environments during which the strategy will out/underperform so that there are no surprises.
  2. When possible, choose strategies that mitigate some of the risks that are manageable (e.g. If you use tactical equity, what kind of whipsaw management does it employ? If you use managed futures, how diversified is it?)
  3. Combine complementary strategies into a comprehensive risk management sleeve.

Ideally, no risk management strategy would fail to manage risk, but there is always the risk that risk management will not work as expected. As we showed in our State of Risk Management, by taking these steps, we can manage the risk of poor risk management in a single strategy and create a combined risk management sleeve that is more robust to short-term fluctuations that are inevitable in any strategy.

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Prior to joining Newfound, he was a chemical engineer at URS, a global engineering firm in the oil, natural gas, and biofuels industry where he was responsible for process simulation development, project economic analysis, and the creation of in-house software. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics.