At a glance
- The worst drawdowns typically happen in recessions. Investors have experienced even worse drawdowns in this bull market than previous ones.
- This is particularly harmful to investors with nearer-term horizons, who are relying on assets they have built up previously, such as retirees who need attractive, sustainable income in their later years – especially now they're living longer.
- Why is this happening now? We believe a changing market structure caused by slower economic growth, central bank intervention and more passive investors in the market could be the culprit
Many commentators are talking about an increasing risk of recession. Our own recession probability models agree, with Figure 1 showing more than a 50% chance of a recession happening in the next two years. As recessions are typically associated with much worse market returns, this increasing risk has led investors to look for defensive strategies that emphasise drawdown management.
We believe that even outside of periods of increased recession risk, defence makes good sense for investors – particularly for those whose investment horizon is limited.
Figure 1: US recessions and Investec two year ahead recession probability model
Forecasts are inherently limited and not a reliable indicator of future results.
Source: Investec Asset Management, 31 August 2019.
We think the nature of markets has evolved since the global financial crisis. Our analysis of markets since 1987 (the year of the Black Monday crash) shows that before 2009, outside of the ‘bear markets’ often associated with recessions – when stock markets drop 20% or more from recent highs – investors tended to see drawdowns that were ‘well-behaved’: an equal weighted bond-equity portfolio suffered very few drawdowns of more than 5%, and never as much as 10%.
By contrast, in the current cycle we have so far seen six episodes of more than 5% drawdown including one of more than 10% – an unprecedented frequency and magnitude of drawdown for a bull market over the last 30 years. This can be seen in Figure 2.
Figure 2: Drawdown of an equal weighted bond/equity portfolio
Source: Bloomberg and Investec Asset Management, 31 July 2019.
Drawdown of equal weighted portfolio refers to MSCI ACWI & WGBI.
Is a changing market structure to blame?
We think there may be multiple drivers of this increased fragility across asset classes:
- The rate of economic growth has been slower over this cycle than in past cycles, meaning the global economy has teetered closer to the edge of recession (and therefore to the risk of severe drawdowns) than it did before.
- To deal with this, central bank market intervention has become more significant and creative than it was previously, potentially leading to a ‘feast or famine’ environment for liquidity.
- The ability of private sector banks to absorb risk has been curtailed by regulation and shareholder demand for their business models to become more dependable.
- Passive ETFs/tracker indices make up a greater proportion of the investor base, potentially leading to more herding into and out of positions, thereby exacerbating market moves.
The number of US-listed ETFs has grown exponentially over the years
The impact of these changes is evident in the number of ‘flash crashes’ – instances when asset values changed significantly over a short period of time – seen in this bull market. These flash crashes aren’t just confined to equity markets (as can be seen in the timeline on the right) and are likely a consequence of liquidity becoming more susceptible to drying up than before.
Impact for investors
This changing market structure and the resulting increased frequency in drawdowns has a significant impact for investors. This risk is particularly relevant for those investors whose horizons are not aligned to the economic environment, but rather to their own specific needs for returns, as their assets may not be able to recover from a drawdown in time to meet their liabilities.
One cohort of investors particularly impacted are retirees, or those approaching retirement. These investors are not able to rely on future earnings being able to fund shortfalls caused by investment losses and so have to depend on the assets they have already built up through their working life. With the world population ageing, these investors are living for longer and so need to make their wealth last for longer. For these investors, drawdowns can be fatal to their investment objectives.
Recent flash crashes
Source: Redburn and Investec Asset Management, 31 August 2019.
Drawdowns – what is needed to recoup losses
Source: Investec Asset Management, 31 August 2019.
Why defence makes sense
The Investec Diversified Income Fund focuses on defensive returns, which we define as having a lower downside capture than upside. We believe this focus makes sense irrespective of the market backdrop to investments.
Figure 4 shows the peak-to-trough performance of the Fund and its peers in the most severe recent drawdown episodes. The blue line shows the least dramatic falls during these challenging periods, meaning our approach shielded against capital losses more so than any of our comparative peers. By then ‘un-hedging’ risk when appropriate, we were able to recover losses more quickly and so avoided the worst of the negative impact.
Figure 4: Peak to trough performance during drawdown episodes
Calendar year % returns for the Fund, Index and Sector, respectively 2018: 0.41, -9.47, -2.97. 2017: 4.82, 13.10, 3.89. 2016: 5.92, 16.75, 2.18. 2015: 1.97, 0.98, 2.30. 2014: 5.32, 1.18, 3.15. 2013: 6.19, 20.81, 7.93.
Source: Morningstar, dates to 31.07.17, performance is for the I-Acc share class, net of fees (NAV based, including ongoing charges) gross income reinvested (net of basic rate UK basic rate tax pre 5 April 2016), in GBP.
Limiting the downside
When the equity market fell, the Fund only experienced 16% of those losses. While if the market gained, the Fund experienced 40% of those gains.
By concentrating on minimising downside correlation (in contrast to many funds which focus on producing no correlation) the Fund has produced more than double the upside capture relative to downside1. This positive skew is a powerful attribute to compound returns in an environment offering little potential capital appreciation.
For investors, the benefit of investing in a defensive fund during a recessionary period should be clear, as the aim to reduce drawdowns in significantly falling markets makes it easier to regain capital in the future.
However, with market structure changes leading to the increased frequency and magnitude of bull market drawdowns and flash crashes, a defensive strategy has an important role in an investor’s portfolio throughout the cycle, particularly for those investors with nearer-term liabilities and needs. We believe this is why defence always makes sense.
1 Investec Diversified Income Fund average monthly gain and loss as a proportion of UK Equities average gain and loss. Source: Investec Asset Management, in GBP gross of fees and taxes with income reinvested, UK Equity returns are for FTSE All Share Index, from 1 September 2012 to 31 August 2019. For further information on indices, please see the Important information section.
Past performance is not a reliable indicator of future results, losses may be made.