Michael J. Chapman, CFP®, CIO
The concept and term of drawdown may be new to many investors, but it is an important factor we at Provident use in our analysis of any investment strategy and within the portfolio as a whole. From a risk-management perspective, drawdown and the mathematics of winning and losing are closely related.
Drawdown is the decline in value from the peak to the trough over a specific time and is usually quoted as a percent. For example, if your investment amount was $100,000 and you lost $50,000, this would represent a 50% loss in value for your investments. Your account equity, the amount remaining, is $50,000 after the drawdown. You will need a gain of $50,000 to bring your investment back to $100,000.
How much gain do you need to bring your remaining investment back to original? If your answer is 50%, then it is wrong, because 50% of $50,000 (account equity after drawdown) is only $25,000, and that would take your account back to only $75,000. You would still be behind $25,000 from your initial investment. So the correct answer is 100%, that is, you will need a 100% return of the remaining $50,000 to bring your investment back to the original position. In summary, this simple example demonstrates that if you have lost 50% of your investment, in this case, then you need 100% gain to restore the financial position of your account to the original position.
The S&P 500 suffered relatively large drawdowns from 2000 through 2009, -49% and -57% from March of 2000 to October of 2002 and from October 2007 to March of 2009, respectively. Since no one has a crystal ball, we do not know what the peak or trough (top or bottom) will be until it is behind us.
Big drawdowns can take a long time to recover one's account back to the original principal amount. It took almost five years (5 years!) to recover from the drawdown of the the S&P 500 after the dot com bubble, and over four years from the drawdown in the S&P 500 that bottomed out in March of 2009.
It is for this reason that active risk management is critical to long-term success when it comes to investing. Many of us, especially retirees, do not have five years to wait for our investments to get back to breakeven. There is also the lost opportunity of time, with respect to compounding the growth of capital and not just compounding the capital to get back to even.
Drawdown can be thought of in simple terms as one's pain threshold. If you have $10,000 and it dropped to $8,000 (20%), would you still be able to sleep at night? What if you opened your statement and it was down $5,000 (50% drawdown) in equity value? As drawdown is a percentage-based measure that one can directly associate with their investment account value, it provides a meaningful sense of the risk one is willing to accept. Since we have all lived through two drawdowns of approximately 50% 2000 through 2009, when looking at the S&P 500, we know what it feels like and how long it has taken to recover. When looking at investments, be sure to consider drawdown.
Disclaimers: Drawdown is a measurement tool, but is not the only risk-measurement tool. Historical drawdowns of and investment, index or strategy does not necessarily represent future drawdowns, performance or offer predictive value for what may happen in the future. No one on the planet has a crystal ball or can say that low drawdown or high drawn investment will continue to operate in the exact same manner.
Michael J. Chapman, CFP®, CIO
Investing with an absolute approach is different from buying and holding. Typically, it involves buying and selling investable instruments with a goal of positive returns every year, regardless of how a relative benchmark is performing. Our absolute investing philosophy centers around this concept and our mission is to bring viable strategies and options that seek absolute returns to the individual investor.
At the center of our absolute investment approach is risk management. As market participants, we can not influence the returns any given investment will provide, that would require a crystal ball, but we can actively manage the risk our portfolios are subjected to.
Our risk management begins at the strategy level and then rolls up to the entire portfolio. Our first objective is to use various strategies, whether created by Provident or other money managers, that tend to offer low correlation to one another. Typically, risk managed at the strategy level may incorporate various options, such as using stop-loss orders, purchasing puts, diversification through the holdings within a strategy and the ability to move to cash.
Managing risk and having an absolute return approach don't guarantee portfolios will be positive every year, but it offers a little more peace of mind when you commit hard-earned capital towards achieving an investment goal. See related articles on drawdown and the mathematics of winning and losing for additional information on the benefits of risk management.
Diversification goes beyond the traditional asset allocation models proposed by many financial professionals. In reality, traditional asset allocation models that focus on dividing a portfolio among growth, value, international, small-cap and large-cap stocks may be subject to more risk than one realizes. The following represents the correlation of stock categories for a traditional diversification approach found in table 1.0 versus the correlation of various Provident Capital Management strategies in table 1.1.
Ideally, one seeking diversification would want to find investment options that are not correlated to one another, meaning the strategies' respective performance moves independently of one another. Typically, the closer the correlation is to zero, the lower the volatility of the portfolio will be, leading to potentially a lower drawdown and a higher risk/reward scenario.
Investment options that are closely correlated (i.e. close to +1) will be found to move in the same direction, minimizing any attempt to achieve diversification. The inverse is also true, investment options that are negatively correlated demonstrate a connection by typically moving in opposite directions.
Provident Capital Management's belief is that superior full-market cycle returns are directly correlated to a reduction or elimination of large drawdowns in any given portfolio or investment strategy. To accomplish this, an investment strategy must employ some form of risk management and should have the ability to capture positive returns in both rising and falling markets. Furthermore, it is important to have the ability to participate in all asset classes, all asset sizes and all asset styles across all markets to insure diversification that is truly non-correlated.
Our firm uses ETF's and stocks to bring to market model driven, quantitative, multi-directional strategies, formerly only available to institutions and accredited investors. These strategies are available in liquid and transparent separate managed accounts offering investors an attractive alternative to the traditional mutual and hedge funds.
Provident Capital Management is committed to providing the investment community with high-quality absolute return and tactical solutions that are liquid and transparent. We offer an attractive alternative to hedge funds, mutual funds and traditional buy and hold strategies.
Tools and research are available to develop strategies that will deliver respectable performance in today's low return environment. Wall Street's preference for "benchmarking" equity managers to traditional equity indexes exposes institutional investors to excessive risk as measured by draw-downs (up to 30% to 50% over the past 5 and 10 years). Furthermore, recent high correlation across all asset classes, especially in times of financial distress, is minimizing benefits of traditional asset allocation.
Provident offers a solution to the dilemma of portfolio shocks and high volatility, large and prolonged draw-downs and cyclical low returns. Provident's strategies can be used in conjunction with traditional asset allocation approaches or used as a distinctive investment methodology. Through its multi-factor quantitative approach Provident's strategies have been built for the present and future. Portfolios and strategies are designed to produce positive returns in up, down and sideways markets.
Through risk mitigation, without sacrificing upside capture, PCM's quantitative strategies reduce portfolio draw-down and enhance returns. Our service is delivered via liquid and transparent separate accounts or LP structure through major custodians such as TD Ameritrade and Schwab. We measure our success by how effective we are at producing positive returns with as little volatility as possible versus comparing our performance to an arbitrary index.
What are Absolute Return Strategies?
"Absolute return funds look to make positive returns whether the overall market is up or down, while index-tracking funds try to beat the index they are tracking." - Forbes, Investopedia
PCM's Absolute Return Strategies use low-volatility investments such as cash and money market funds, and then at times selected by the manager, will take directional positions in index Exchange Traded Funds. The strategies historically offer low correlation to financial market performance such as the Standard and Poors 500 Stock Index (S&P 500 Index).
Michael J. Chapman, CFP®, CIO
Adopting Tactical and Absolute Return Strategies, which use risk management can, under the right circumstances, out perform and potentially reduce losses more than traditional buy and hold / benchmark strategies during weak cycles.
The past 200 years of stock market history show that weak performance periods follow strong periods. We may be witnessing the completion of a strong cycle here in fall of 2020.
Time Period Annual Average Return Duration
1815-1835 10.0% 20 Years
1843-1853 13.7% 10 Years
1861-1881 12.0% 20 Years
1987-1902 15.2% 5 Years
1921-1929 25.2% 8 Years
1949-1966 14.0% 17 Years
1982-1999 14.9% 17 Years
2009 - 2020 16.1% 11 Years
Average 14.8% 13.5Years
Weak periods have lasted up to 20 years
Time Period Annual Average Return Duration
1802-1815 +2.7% 13 Years
1835-1843 -0.6% 8 Years
1853-1861 -3.0% 8 Years
1981-1897 +3.9% 16 Years
1902-1921 0.0% 19 Years
1929-1949 +0.8% 20 Years
1966-1982 -1.4% 16 Years
1999- 2009 -8.4% 9 Years
Average -0.75% 15.1 Years
We are 11 years into a strong cycle, Valuations are stretched to levels not seen since 1999, the end of the dot com period. Now would be a good time to consider adding a absolute return and or tactical approach to your investment portfolio.
Past performance does not guarantee future returns. The success or failure of a tactical and absolute return strategy depends upon many factors including but not limited to the managers's ability to avoid large market losses. There can be no guarantee that PCM will be able to avoid such losses or that PCM will be able to identify periods of week performance in the stock market in the future.
Weak and Strong Market Cycles is research by Robert Powers and Sy Harding Market Cycles Study. The Table above summarized Powers' interpretations of strong and weak cycles, along with average annual returns adjusted for inflation and duration of the cycle
PCM Strategic Equity TR SM
The objective of PCM's Strategic Equity TR IndexSM is to achieve total return with a secondary objective of little to no correlation to equities and bonds. The index will strive to achieve its objective by investing in a basket of pre-selected industrial and precious metal ETFs, including but not limited to gold, silver, platinum, nickel, and aluminum ETFs. Presently the only inverse ETF is DGZ (an inverse gold ETN). The index may rotate bi-monthly.
Provident Capital Management Inc. Absolute IndexesSM Disclosure:
PCM Absolute Indexes represent model and hypothetical performance prior to April 2011 and actual model performance going forward to current date.
One cannot invest directly in this index. One can only invest in accounts that attempt to track the holdings and results of the index. There is no guarantee that any client will achieve performance similar to, or better than, an index mentioned herein.
Provident Capital Management, Inc. owns and actively manages quantitative indexes that have an absolute, total-return approach. The indexes are rebalance bi-weekly, monthly or quarterly depending on the index. Periodic adjustments to structure or strategy may be made from time to time at the discretion of Provident Capital's Investment Committee.
Third-party investment professionals, including, but not limited to registered investment advisors and broker/dealers, may make available separate managed accounts (SMAs) that attempt to track our indexes. Provident Capital Management, Inc. makes available SMA’s that attempt to track our indexes. PCM maintains full discretion in implementing SMA’s for clients. Difference in holdings and percentage of holdings between actual accounts and the index may occur. PCM's Absolute Index selection uses an approach selecting the ETFs based upon a multi-factor quantitative approach.
There are three primary types of actively managed indexes developed and managed by PCM:
1. Macro: Broad based equities, fixed income, currencies and commodities.
2. Tactical: Equities and fixed income specific to countries, sectors and certain commodity ETFs.
3. Asset Class Specific: Such as Strategic Equity TR Index, or Absolute Currency Index.
PCM’s index performance reflects the reinvestment of dividends from January 1, 2003 through December 31 2010 and no reinvestment of dividends January 1, 2011 through present. Performance does not include management custodial or trading fees. Investment products that may be based on Provident Capital Management’s Absolute IndexesSM are not necessarily sponsored by Provident Capital Management, Inc. and Provident Capital Management or any affiliate, advisor or representative does not make any representation regarding the advisability of investing in them. Indexes have an inception date of January 1, 2003 unless otherwise noted in this document. Inclusion of a mutual fund or exchange traded fund in an index does not in any way reflect an opinion of Provident Capital Management regarding the investment merits of such a fund. None of the funds included in the index have given any real or implied endorsement or support to Provident Capital Management or to any index owned or operated by Provident Capital Management.
January 2011 Provident Capital Management started reporting index results monthly to Morningstar. January, 2 2012 Provident Capital Management switched from monthly reporting to daily reporting. Daily reporting was through an electric submission process and is the calculated index value based upon the closing price of the underlying index holdings.
As this is an actively managed index Provident Capital Management may add or remove ETF candidates for any reason including but not limited to volume, liquidity and ETF issuer related events.
Absolute Indexes typically include one or more ETFs that are inverse to the long positions. The inverse ETFs must meet the same criteria as the long ETFs to be included in the active index. Should the ETF(s) not meet the inclusion criteria then the percent allocated to the non-investable ETF will rotate into cash or a cash equivalent ETF. As the index selects a number of ETFs based upon the quantitative criteria for the index, and if the respective Index includes an inverse ETF, it is possible that the index may be simultaneously in a long position and an inverse position in the same asset class or even similar ETF.
One cannot invest directly in an index. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. One of the limitations of hypothetical model performance results is that they are prepared with the benefit of hindsight. There are numerous other factors related to the markets in general or to the implementation of any specific trading or investment strategy which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
Not all ETFs that are current candidates for the Absolute Index were available during the timeframe reported. Provident Capital’s Investment Committee makes every attempt to stay current with the availability of ETFs or other investments that may meet the standards of liquidity and transparency to be included as a candidate in any of the indexes. Results shown are for the index, not actual performance in any Provident Capital accounts. Returns shown are not indicative of actual performance for any client account. Although data shown is gathered from sources believed to be reliable, Provident Capital Management, Inc. cannot guarantee completeness and/or accuracy.
Inclusion of a mutual fund or an exchange traded fund in a Provident Capital index does not in any way reflect an opinion of Provident Capital Management, its Directors, Officers or employees regarding the investment merits of such a fund, nor should it be interpreted as an offer to buy or sell such fund’s securities. None of the mutual funds or exchange traded funds included in an index has given any real or implied endorsement or support to Provident Capital or to this index. Used as supplemental sales literature, the index or portfolio reports must be preceded or accompanied by the current disclosure. The underlying holdings of the portfolio are not federally or FDIC-insured and are not deposits or obligations of, or guaranteed by, any financial institution. Investment in securities involve investment risks including possible loss of principal and fluctuation in value.
The information contained in this report is from the most recent information available to Provident Capital Management as of the release date, and may or may not be an accurate reflection of the current composition of the securities included in the portfolio. There is no assurance that the weightings, composition and ratios will remain the same.
Benchmark Returns and Non-Provident Capital Management Indexes
Benchmark returns may or may not be adjusted to reflect ongoing expenses such as sales charges. An investment's portfolio may differ significantly from the securities in the benchmark.
S&P Diversified Trends Indicator TR (SPDTT) Follows a quantitative methodology that tracks a diversified portfolio of 24 commodity and financial futures contracts. Can go either long or short, the (SPDTT) is designed to capture the economic benefit derived from both rising or declining trends within a cross-section of futures markets.
SPDR Gold Shares (GLD) The SPDR® Gold Trust is designed for the Shares to reflect the performance of the price of gold bullion, less the Trust's expenses. SPDR Gold Shares are designed to track the price of a tenth of an ounce of gold.
iShares S&P GSCI Commodity-Indexed ETF (GSG) The iShares S&P GSCI Commodity-Indexed Trust (the 'Trust') seeks to track the results of a fully collateralized investment in futures contracts on an index composed of a diversified group of commodities futures.
PowerShares DB US Dollar Bullish ETF (UUP) PowerShares DB US Dollar Index Bullish tracks the performance of the U.S. dollar against a basket of developed-markets currencies. Tracks the value of the U.S. dollar relative to a basket of the six major world currencies - the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss.
Barclays Global Aggregate TR A measure of global investment grade debt from twenty-four different local currency markets. This multi-currency benchmark includes fixed-rate treasury, government-related, corporate and securitized bonds from both developed and emerging markets issuers.
IShares MSCI EAFE (EFA) The iShares MSCI EAFE ETF seeks to track the investment results of an index composed of large- and mid-capitalization developed market equities, excluding the U.S. and Canada.
WisdomTree Global Equity Income Index (DEW) The WisdomTree Global Equity Income Index ETF* is a fundamentally weighted index that measures the performance of high dividend-yielding companies selected from the WisdomTree Global Dividend Index, which measures the performance of dividend-paying companies in the U.S., developed and emerging markets.
Standard and Poor (S&P 500) An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
iShares MSCI Emerging Markets Index (EEM) The iShares MSCI Emerging Markets ETF seeks to track the investment results of an index composed of large- and mid-capitalization emerging market equities.
iShares Core US Aggregate Bond (AGG) The Index Is composed of securities from the Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.
iShares JPM USD Emerging Markets Bond (EMB) Tracks total returns for U.S. dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds.
S&P Target Risk Conservative PR (SPTGCU) The S&P Target Risk Conservative Index emphasizes exposure to fixed income in order to produce a consistent income stream and avoid excessive volatility of returns.
Citi WGBI Non-USD® (WGBI) measures the performance of fixed-rate, local currency, investment-grade sovereign bonds. The WGBI is a widely used benchmark that currently comprises sovereign debt of over 20 countries, denominated in a variety of currencies, and has more than 25 years history available. The WGBI is a broad benchmark providing exposure to the global sovereign fixed income market. The index provides exposure to a broad array of countries. Sub-indices are available in any combination of currency, maturity, and rating.
Each of the above Benchmark indexes is included merely to show general trends in the market during the periods indicated. Inclusion of these Benchmark indexes is provided only for reference purposes and is not intended to imply that any Provident Capital Management index was comparable to any Benchmark index in either composition or element of risk. There is no guarantee that any client will achieve performance similar to, or better than, a Benchmark index mentioned herein.
No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Any projections, market outlooks or estimates in this presentation are forward-looking statements and are based upon certain assumptions and should not be construed as indicative of actual events that will occur. Provident may change the exposures and index compositions reflected herein at any time and in any manner in response to market conditions or other factors without prior notice to investors.
None of PCM indexes referred to herein reflect the deduction of the fees and expenses to be borne by a client, whose separately managed account may trade and invest in different financial instruments than those in a particular index. Concentration, volatility and other risk characteristics of a client’s account also may differ from the indexes shown herein.
PCM Strategic Equity TR CompositeSM will be published once it has 18 months of data.
I. Explanation of Performance for PCM Strategic Equity TR CompositeSM
a. Provident Capital Management, Inc.(PCM) is a fee-only Registered Investment Advisor under the Investment Advisor’s Act of 1940. Its office is located at 11595 N.Meridian Street, Carmel, Indiana. PCM is defined as an independent investment management firm that is not affiliated with any parent organization. PCM manages client portfolios in separate accounts.
b. The performance numbers are the value-weighted, time-weighted, and total return composite results of all fully discretionary PCM Strategic Equity TR CompositeSM accounts held at various custodians. Composite performance is measured on a monthly basis and linked to obtain the quarterly and annual results. New accounts are added as of the first of the month following the month in which the account is funded. The composite includes all accounts held in this strategy. Valuation at the end of each month is based upon prices provided by the custodian.
c. The benchmark index for the PCM Strategic Equity TR CompositeSM is the SPDR Gold Trust ETF (GLD)®. PCM believes that the SPDR Gold Trust ETF (GLD)® is a benchmark that is widely used and understood by the investment community. PCM’s Strategic Equity TR CompositeSM objective is to produce positive returns each year.
d. Valuations are computed in U.S. Dollars.
e. Performance results for the PCM Strategic Equity TR CompositeSM net-of-fee returns reinvested dividends and interest and are presented after the deduction of actual management fees, performance-based fees, and bundled fees.
f. The PCM Strategic Equity TR CompositeSM was created 1 September 2014. PCM claims compliance with the Global Investment Performance Standards (GIPS®). To receive a complete list and description of the firm’s composites and/or a presentation that adheres to the GIPS® standards, please contact the firm at the address listed.
II. Important Performance Disclosures
a. Past performance is no guarantee of future performance.
b. Individual account performance will vary.
c. The PCM Strategic Equity TR CompositeSM strategy seeks to minimize downside risk. However, no assurances canbe given that this objective will be accomplished.
III. Index Descriptions
a. The SPDR Gold Trust issues SPDR Gold Shares, which represent units of fractional undivided beneficial interest in and ownership of the Trust. The investment objective of the Trust is for the Shares to reflect the performance of the price of gold bullion, less expenses of the Trust’s operations. The Shares provide investors with a cost-effective, convenient, and flexible way to invest in gold.
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