• Post author:

Investors dislike volatility, but what they really despise are drawdowns. Drawdowns are a measure of pain – it’s money they feel they had at one point, but is now gone.

As an advisor once remarked to me, “My clients may not understand standard deviation or tracking error, but they certainly understand when they’re losing money!”

Recognizing the strong demand for drawdown controls, Innovator ETFs has recently launched a series of Defined Outcome ETFs, with drawdown limits (buffers) set at 9, 15 or 30 percent over fixed investment horizons. While this is a helpful and innovative first step in offering risk control to retail investors, both the buffers and the time horizons are necessarily fixed because of the co-mingled “one-size-fits-all” nature of ETFs. Further, they are implemented using expensive option contracts and therefore might not be viable for many investors.

The good news is that with intelligent asset allocation, financial advisors and investors can exercise precise control over drawdowns, easily and effectively using inexpensive direct holdings of stocks and without the use of derivatives. They can set controls such as buffers and reset dates for each individual investor’s account, across a wide range of strategies via Optimal’s Goal Optimizing Outcome-Shaping Engine (which we call GOOSE).


Drawdowns are worse than volatility

Portfolios with higher drawdowns will be looked at unfavorably by most investors, even if they have shown lower volatility overall. This is no surprise.

First, losses require a higher percentage of subsequent returns to fully recover. For instance, to recover from a 20% loss you need a 25% return just to get back to where you were.

Second, these losses can be devastating if they occur right when a liquidity requirement is imminent. This timing risk should be mitigated as much as possible, taking into account the unique (and ever changing) circumstances of each individual investor.

While retail investors have traditionally been expected to “bear it and wait for the turnaround” institutional-style risk control strategies can easily be deployed to implement drawdown limits.


Implementing drawdown constraints is as easy as pushing a button

GOOSE by Optimal lets the advisor precisely control the highest possible portfolio loss by setting a maximum loss-level goal (as a percentage of the highest peak over a defined trailing period), which we call a “downside floor”. The GOOSE™ engine then monitors and rebalances the account with the objective of maximizing the likelihood of hitting an upside target without violating the downside floor implied by the drawdown limit.

For the stock exposure (the “upside-seeking strategy”), Optimal offers an extensive strategy library that includes S&P Dow Jones indices such as the S&P500 as well as blends of S&P factor indices such as value, momentum, low vol and quality, and Optimal’s own in-house built tactical (Dynamic Alpha) and multi-factor (Premia Harvest) strategies.

In our next blog article, we’ll consider a few client cases and assess how downside floors set at varying levels affect portfolio returns.

Teun Lucas is head of sales and client relations at Optimal. Optimal Asset Management is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940, as amended.

Teun Lucas

Teun Lucas, CFA joins Optimal from MSCI and prior to that JPMorgan in London and Amsterdam, where he worked with Advisors and Pension Funds on Smart Beta, Factor based solutions and Equity Derivatives. He was also a senior account manager for institutional clients at Northern Trust in London. Teun has an MS in Finance and Investments, Cum Laude, from the Erasmus University in Rotterdam, Netherlands.