Funds with the lowest drawdowns have substantially outperformed those with the highest drawdowns over the long term, according to the latest FE Trustnet study, highlighting just how important capital preservation can be for investors.
Regular readers of FE Trustnet will by now know of our love of maximum drawdown, which measures the most an investor would have lost if they bought and sold at the worst possible times, as while it shouldn’t be used in isolation when assessing a fund it is nonetheless important for establishing a portfolio’s track record at protecting capital.
Though a number of our commenters have suggested maximum drawdown is a largely irrelevant metric, our most recent study highlights that funds with the lowest drawdowns have substantially outperformed those with the highest drawdowns over the long term in nearly every Investment Association sector we looked at.
Of course, the major flaw with the research is that it is backward looking and is therefore offers very little in terms of future performance, but it does reveal how important a fund’s capital preservation characteristics have been to its total return.
For the study, we built equally weighted portfolios of the funds with which were top quartile (or top decile if there were more than 200 in the sector) for maximum drawdown over 10 years and plotted them against equally weighted portfolios of the funds which were bottom quartile (or decile) for their drawdowns over that time.
One of the most striking results came from the highly competitive IA UK All Companies sector, as the graph below shows.
Performance of composite portfolios versus index over 10yrs
Source: FE Analytics
According to FE Analytics, the portfolio of funds with the lowest maximum drawdowns has outperformed the portfolio of those with the highest maximum drawdowns by 50 percentage points over the last 10 years.
Also, the funds with the highest drawdowns have only narrowly outperformed the FTSE All Share over that time – thanks to the portfolio’s strong returns after the market bottomed following the financial crisis.
It is a similar situation in the other UK equity sectors, as in the IA UK Equity Income peer group and the IA UK Smaller Companies sectors the difference in performance between funds with the lowest and highest maximum drawdowns over the last 10 years has been 25.89 percentage points and 113.5 percentage points respectively.
As the table below, the trend continues across the other equity Investment Association peer groups. The table illustrates the portfolios’ maximum drawdown and total returns over the last 10 years.
Source: FE Analytics
Within the IA UK All Companies space, each member of lowest drawdown portfolio has outperformed both the sector average and the FTSE All Share over the last 10 years.
They include the likes of Majedie UK Focus and Majedie UK Equity, which have outperformed in nine out of the last 10 calendar years and have had maximum drawdowns of 35 per cent over the period in questions.
Others which feature are Mark Barnett’s three Invesco Perpetual income funds, Jupiter UK Special Situations and the Liontrust Macro UK Growth fund, which is headed-up by the FE Alpha Manager ‘hall of fame’ duo of Stephen Bailey and Jan Luthman.
However, while the portfolio of IA UK All Companies funds with the highest maximum drawdown has considerably underperformed against those which have protected capital more effectively, there are a number of its members which have bucked the trend.
The Standard Life UK Equity High Alpha fund, for example, has been the sixth best performer out of the 182 funds which have a long enough track record in the sector over 10 years with returns of 235.53 per cent – but has had the seventh highest maximum drawdown of 58.63 per cent.
That is because while the multi-cap fund was bottom decile in the crash year in of 2008 with losses of more than 40 per cent and again in the falling market of 2011 when it was down 18 per cent, it was top decile in the rising markets of 2005, 2006, 2009, 2010 and 2012.
The likes of GVO UK Focus and Cavendish Opportunities, which have historically had high weightings to mid and small-caps, have also been bottom decile maximum drawdown but top quartile for total returns.
There are also sectors which have gone against the grain; namely in the world of fixed income.
While funds with highest maximum drawdown in the IA Sterling Corporate Bond sector have underperformed their rivals with the lowest drawdowns by 15 percentage points over the past 10 years, the complete opposite is true in the IA Strategic Bond sector.
Performance of composite portfolios over 10yrs
Source: FE Analytics
While the graph clearly shows they fell considerably further during the financial crisis, they have rallied hard over the last six years or so. It must be noted that the sector is somewhat of a mixed bag, though, with those that have high weightings to equities and high yield littering the portfolio of funds with the highest maximum drawdown.
While there have been exceptions, the research shows that in the majority of cases funds which have exposed their investors to the largest market falls have underperformed against those which have protected capital more effectively.
The major reason for that is relatively simple: if a fund were to lose, say, 30 per cent in a year, it needs to make 43.8 per cent in the next to get back to where it started. If it were to fall 40 per cent, it would need to make more than 66 per cent to break even and if it fell 50 per cent it would have to more than double its money to get back to positive territory.
As mentioned earlier, this study relies on past performance and therefore doesn’t guarantee future outcomes. Nevertheless, Ben Willis – head of research at Whitechurch – says that investors should keep a close eye on maximum drawdown when selecting a fund. 
“Capital preservation is very important when looking for core exposure and maximum drawdown is an important element to that as you want a fund that can protect on the downside but participate on the upside,” Willis (pictured) said.
“If you want more tactical exposure you may want to try and find a fund which will be top quartile one year and bottom quartile the next; particularly if you are trying to time your entry at the bottom of the market. However, for core exposure, drawdown is definitely important.”
Willis says, however, it is no easy feat finding funds which can defend money in the future. As a result, he says investors cannot work out a fund’s ability to protect capital without partly relying on its past performance.
“You have to look at the empirical data and measure a fund’s behaviour in different market conditions. It isn’t forward thinking, but you ally that data with your own outlook,” he explained.
“You have to have a starting point but once you have screened through funds you go into more granular data and use more qualitative research such as its correlation, historical correlation, current holdings and historical positioning.”
He added: “Hopefully then you can find a fund which suits your objectives.”
