Finding a fund that was one of the best members of its peer group for protecting capital during past market crashes offers investors little indication on whether it will help shield them from future sell-offs, research by FE Trustnet suggests.
The phrase ‘past performance is no guide to future returns’ is well known in investment circles but it appears that past losses are no guide to future falls either, as our studies shows that more than half of the UK funds that were top decile for maximum drawdown in the global financial crisis performed worse than their average peer in the most recent market correction.
Maximum drawdown – or the most an investor would have lost if they bought and sold at the worst possible times of a given period – is an important metric when assessing past performance but some of our readers (especially Theo) have questioned its usefulness in anticipating future losses.
We put the IA UK All Companies and IA UK Equity Income sectors – two of most popular peer groups with our readers – under the spotlight to see if maximum drawdowns from the past have been any help to investors seeking funds to protect them from future downsides.
Between 15 June 2007 and 12 March 2009, the FTSE All Share was hit by a 41.09 fall as investor sentiment froze in the midst of the global financial crisis. The average IA UK All Companies fund’s maximum drawdown was 41.71 per cent while for the IA UK Equity Income sector it was 39.43 per cent.
Across the two sectors, there were 28 funds in the top decile for maximum drawdown, with the falls ranging from Trojan Income’s 21.64 per cent to Neptune UK Opportunities’ 34.19 per cent. However, investors buying into some of these funds in the expectation that they would defend against future falls would have been disappointed.
Of the 28 portfolios in the financial crisis period’s first decile just six were able to repeat this between 25 May 2015 and 15 February 2016, during which period the FTSE All Share had a maximum drawdown of 11.12 per cent on the back of plunging commodity prices and slowing growth in China.
UK funds' maximum drawdown decile ranking in 2015 falls
Source: FE Analytics
Paul Stephany’s Newton UK Opportunities has been the best performer from a maximum drawdown point of view, after posting a 4.26 per cent fall. Stephany’s Newton UK Equity fund is in second place with a 5.64 per cent maximum drawdown.
It’s important to note that Stephany was not at the helm of either of these funds in 2008, however. Newton UK Opportunities was being run by Ben Russon while Christopher Metcalfe was in charge of Newton UK Equity.
Unicorn Outstanding British Companies, on the other hand, is in third place with a 5.87 per cent maximum drawdown and has had the same manager in place during the two periods. FE Alpha Manager Chris Hutchinson was appointed to the fund at the end of 2006 and has delivered strong outperformance of both his average peer and the FTSE All Share since then.
Performance of fund vs sector and index under Hutchinson
Source: FE Analytics
Within those 28 first-decile funds from the crisis drawdown period, however, there 15 that have a higher maximum drawdown than there average peer and 13 that lost more than the index.
Those with higher maximum drawdowns than the FTSE All Share include the likes of Majedie UK Equity, Majedie UK Focus, Elite Charteris Premium Income, Jupiter Growth & Income and Neptune UK Opportunities.
The same can be seen if the criteria is widened to the first three deciles for maximum drawdown in the financial crisis, so looking at the top third of the sectors. Of the 81 funds, only 26 were in the top three deciles for maximum drawdown during the most recent sell-off, while 21 were in the bottom three deciles.
Changing the start point of the study to use periods of market stress other than the financial crisis as the basis for picking a fund yields similar, unsatisfactory results. Top-decile funds in times such as the eurozone debt crisis and the taper tantrum, for example, seemed just as likely to underperform as outperform in 2015’s sell-off.
However, while researching this article we did find a number of UK funds that have managed to post a lower maximum drawdown than the FTSE All Share across the tech crash, the financial crisis, the eurozone debt crisis, the taper tantrum and the 2015 sell-off. We’ll reveal these in a gallery-article later today.
Stephen Lennon, investment manager at Parmenion Capital Partners, says these findings highlight the dangers of using one metric in isolation and warns that maximum drawdown should be considered with other pieces of data in order to be effective.
“Maximum drawdown can be useful but only when used in conjunction with other metrics. As we all know past performance is no guide to future returns and so maximum drawdown is no different. When using maximum drawdown I would advocate looking a number of discrete as well as cumulative periods in order to help identify those funds which have historically been able to protect capital consistently,” he said.
If we flip the results on their head we can see how the first-decile funds of 2015’s sell-off performed from a maximum drawdown point of view in the financial crisis.
The below graph shows the ranking of the top-decile funds in the recent correction during the global financial sell-off.
UK funds' maximum decile ranking in financial crisis
Source: FE Analytics
As can be seen, only six of the 23 funds were top decile back in the 2008 crash but investors might well have ruled out the 11 that were in the eighth, ninth and tenth deciles, only to see them deliver low maximum drawdowns in the most recent correction.
The results are not too surprising, as each sell-off will have different causes and therefore see different parts of the market hit. A fund that went through a market correction relatively unscathed can easily find that its holdings are very much in the eye of the storm the next time around, leading to a fall in its relative maximum drawdown rankings.
When it comes to assessing a fund’s potential to protect against extreme market falls, Lennon says maximum drawdown should be considered alongside a range of other metrics, including the information ratio, the Sortino ratio and Skewness.
“Our favoured metrics are the information ratio, which measures how much alpha has been delivered per unit of additional risk (i.e. tracking error), and the Sortino ratio,” he said.
“Sortino is similar to Sharpe in that it measures risk-adjusted returns but it specifically penalises for downside volatility, whereas Sharpe penalises for both upside and downside volatility equally. Therefore, a fund with a higher Sortino is one that has protected capital on the downside more effectively.”
Skewness looks at the asymmetry of a fund’s returns from the normal distribution; if the return data points are skewed to the left then it has a ‘negative skew’, which some could interpret as meanings future data points are likely to be less than the mean, while a skew to the right is a ‘positive skew’ and can suggest the opposite.
“Finally, another measure which could be considered is the distribution of returns and their Skewness. A fund which has experienced fatter left-hand tails of returns has a highly negative Skew in the distribution of returns. This would be less desirable when compared to a fund with a shorter, thinner left hand tail and a less negative or positive Skew in the distribution.”
In a coming study, the FE Trustnet team will use the above metrics to highlight potential funds for investors seeking downside protection. But before that, the next article of the morning will reveal 13 UK funds that have persistently dodged the worst of FTSE falls.
