Capital preservation strategies are popular amongst the retirement set and those with an overall unwillingness to risk losing their savings. While these approaches tap safe investment vehicles like Treasury bills and certificates of deposit, investors simply can’t rely on them alone because of their lower interest rates and inflation risk.Also, with Americans living longer today, they need to invest in assets with more upside potential and assume a different type of risk – drawdown (loss of capital) risk.
In figure 2, the drawdown graph brings all peak-to-trough losses to scale, and provides a good visual of the depth, duration, and frequency of all losses. It paints a different picture of the 1987 crash; the S&P 500 lost nearly 30 percent and took almost two years to recover, hardly insignificant.
The corresponding drawdown table in figure 4 indicates maximum drawdown, or what the largest loss would be if an investor bought at the peak and sold at the trough. In this case it was -41.87 percent. We can also see the timing of this drawdown and the duration. The max drawdown is a very telling metric, but it excludes all other drawdowns that occurred over its lifetime. Other metrics are available to address this issue.
Figure 4 also displays the Pain Index and Pain Ratio, statistics which show how a manager performed during a downtrend and quantify their capital preservation tendencies.The Pain Index measures the depth, duration, and frequency of all periods of losses. (The blue shaded area in figure 3 is the area that the pain index is measuring.) Advisors want to see the periods of loss to be less than that of the benchmark.
Figure 5 shows how much excess return a manager earns per level of downside risk. Like other return/risk graphs, one looks for managers who plot in the upper left hand corner, or managers with a lower pain index than that benchmark and positive excess return. Investors concerned about capital preservation want to invest in managers that limit downside losses but also have potential for excess returns.The Pain Ratio takes the next step and creates a ratio using the manager’s excess return over the risk- free rate, divided by the depth, duration and frequency of losses (Pain Index). If this metric sounds familiar, it should – it’s very similar to the Sharpe Ratio. The difference between the Sharpe Ratio and the Pain Ratio is the risk statistic used as the denominator. The Sharpe Ratio uses standard deviation as its risk measure whereas the Pain Ratio uses the Pain Index. The Pain Ratio shows how much return a manager is earning per level of downside risk. As seen in Figure 4, Fund ABC has a higher Pain Ratio, so the fund was able to experience more gains over the risk-free rate while experiencing fewer losses.
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