The True Risks of Trading as Defined by the Underwater Equity Curve

There are a number of ways to measure the risks associated with an investment. One of the risk evaluation tools used by Talon Eight is the Underwater Equity Curve. This "Did You Know" will serve to quantify the historic risks of trading various indices.

Beginning with the basics, an equity curve is a graphical representation of trading performance over time. The equity growth chart (Chart 1) represents the growth of a fictitious $1,000 investment made in the S&P 500 Index over 23+ years. Points A – F represent sharp and prolonged periods of drawdown. The limitation with this equity chart is that they lead investors to focus entirely on profit potential.

Chart 1: Equity Curve, S&P 500, Jan 85 - Mar 09

Point A , Oct 87 Black Monday Point B, Oct 90 Gulf War Point C, Aug 98 Russian Credit Point D, Sep 01 Terror Attacks Point E, Feb 03 Enron Collapse Point F, Feb 09 Credit Crisis

The underwater equity curve (Chart 2) analyzes a different aspect of performance. This equity curve plots the downside risk exposure experienced by an investor trading in the major indices over time. Unlike most equity curves, the underwater equity curve centers exclusively on equity drawdown. Points A – F present periods of drawdown in the S&P 500 Index. These same points were used in traditional equity curve but they become much more pronounced when illustrated in an underwater equity curve. This unique perspective allows investors to view trading performance from a risk exposure point of view. This ensures that an investor is properly prepared to follow the index through good and bad times. Every index and trading program experiences periods of poor performance. The underwater equity curve simply focuses on the magnitude and duration of each drawdown, or sell off from peak levels, experienced by the investment.

The underwater equity curve is constructed using monthly data. At the end of each month, an investment will either break even, generate a profit or experience a loss. If the investment breaks even there is no effect on the underwater equity curve. If an investment ends the month with a profit greater than any previous month, then a blank space is plotted on the graph signifying the new equity high (without noting the magnitude of the high).

When an investment ends the month with a loss, it experiences a reduction in capital also known as an equity drawdown. The underwater equity curve plots this reduction as the percentage lost from the highest point on the equity curve. The drawdown continues until a new monthly equity high is achieved. This focus on drawdown's is deliberate because it forces an investor to review the indices historical performance from a risk exposure point of view.

Let's take a closer look at specific periods of drawdown across three separate asset classes; stocks, bonds and Managed Futures. Stocks will be represented by the S&P 500 Index, Bonds by the Barclays Capital US Aggregate Bond Index and Managed Futures by the Credit Suisse Managed Futures Index (MFI).

The Charts and Tables below, clearly shows that the S&P 500 Index has experienced two dramatic drawdowns over the past 15 years. Specifically stock investors have had to endure a 46.28% drawdown that lasted a total of 6.75 years (81 months) and they are presently experiencing a 52.56% drawdown that has been active for 17+ months. During the same time span The managed futures Index (MFI) has fared far better with two drawdowns experiencing 17.74% and 14.22%. More importantly the duration of each of these drawdowns were in the 2 year (24 month) time range. When we compare the active management style associated with the Managed Futures Index against the passive management style associated with the S&P 500 index we historically see smaller drawdowns with less duration. [More]

Bonds have been included in our drawdown analysis because they play an important role in diversifying a portfolio. These passive investments are however not immune to periods of drawdown. Their drawdown numbers are far less than either stocks or managed futures products. The two top drawdowns for bonds run 5.15% and 3.82% with durations lasting in total around a year. The reality is that even "safe" investments like those of bonds experience drawdowns.

Chart 3: Asset Class Underwater Equity Curves, Stocks, Bonds and Managed Futures Jan 94 - Mar 09

The reference numbers on Chart 3 correspond to the two largest drawdowns experienced by each asset class as shown on Table below.

Table 1: Asset Class Drawdown

Notice the substantial historic drawdowns experienced by the stock indices versus the bond and managed futures indices. The top two drawdowns experienced by the stock market double the largest drawdowns of Bonds and MFI. Measuring risk with the underwater equity curve allows investors to clearly note the risk associated with a particular investment.

Let's take a quick look at the active drawdowns currently underway in the world markets. Although the S&P 500 Index is in the midst of a substantial drawdown second only to the 1929 Crash ... other world markets are experiencing even greater sell offs.

[Return to Research]