We are updating our 'Volatility vs Subsequent Drawdown' Chart for 2011.   We did a similar post a year ago and you can review that blog post here: Understanding ETF Volatility Part 1.

The way to read these charts is to simply note the relationship.   By definition, high standard deviation investments offer wider opportunities for both out and underperformance.  The S&P 500 dropped -18.6% off its high during 2011 (using closing total return values).   This was -3.2% worse than the mid-year loss in 2010, when the S&P dropped -15.6%.   

Gold had a more normal drawdown in 2011 at -17.5% vs 2010's -7.8%, due mostly to its more aggressive slope up during the summer.   Gold never got particularly volatile in 2010 but in 2011 it traded more typical of a commodity market -- where there is often a momentum-oriented blow-off move.   Still, if you were watching volatility dynamically, you would take note of it becoming riskier during the July-August advance.   

The NASDAQ-100 actually dropped slightly less from high to low in 2011 vs 2010.  Large-cap tech -- particulary AAPL have been relatively calm in 2011 -- which was also the case in 2010.   Can it go 3 years with just a mid-teens drawdown?  We don't know but there are certainly other more attractive segments as we close 2011.

It may sound odd but the losses in both 1) small cap US stocks (IWM) and 2) US Energy stocks (XLE) were about the same from high to low as the European ETF (VGK), which dropped -30%.   However, both of the US ETFs have seen strong rebounds in Q4 and are a few percentage points from flat on the year.

Silver (SLV) is pretty consistently the most volatile (unlevered) ETF around and it didn't disappoint with a -41% high to low move in 2011 (and the year isn't quite over).

Treasury bonds ground out fantatstic years.   We've blogged many times about how intermediate and low-duration bonds are the ultimate safe-haven.   You can't count on consistent correlations in times of crisis -- but you can count on low-duration bonds,  the fixed-maturity dates of the underlying securities ensure it.  This is not true of long-term bonds -- which look susceptible to significant drawdowns in 2012.  As much hype as the US downgrade received, it proved yet another meaningless move by the ratings agencies in the United States, which for some antiquated reasons seem to remain relevant to some.

Note that many ETF providers launched 'minimum volatility' ETFs in 2011.  Since starting ETFreplay.com in early 2010 we have always used volatility as 1 of 3 key inputs in our multi-factor screener model -- so we are not surprised to see this development from the ETF providers.   Volatility has and always will be important --- but it's certainly not the only thing that matters.  Myopically focusing on volatility is taking this all too far as building ETFs off a singular concept like this is very limiting.  

We view risk-adjusted (volatility-adjusted) relative strength as the cornerstone philosophy of ETFeplay.com and this led to a fixed-income bias throughout most of 2011.  However, a tactical investment process continually looks to adapt to the environment --- and we would look for continue rotations in 2012 --- and every other year for that matter.   There is plenty of room to add value in any year and it's up to you to figure out which group that is and how to manage it.  In 2011, fixed-income ETF showed excellent total returns.  You can't always be right of course --- but you can pursue a process on thoughtful consideration of which markets to be involved with --- and then layering some trend-following techniques on top of that ---  all the while continually striving to protect yourself for the times you are wrong.   If you simply stay consistently loaded in a group of highly volatile securities -- it is just a matter of time before you have a large drawdown. 

As can be seen in our tracked Portfolio Allocations, we view equities to be attractive as we end 2011 -- particularly small and midcap US stocks.  We see signs of P/E multiple expansion with rates low and liquidity being added to the problem areas of the global economy.  However, even assuming we enter an intermediate uptrend (which may or may not occur), this does not mean that more rotations within the markets won't occur.  It is never easy in the moment and we will carefully continue to watch and adapt to new potential themes/trends --- while always watching our backs to avoid too much portfolio volatility (and its associated drawdown).

Volatility is a tough topic to get your hands around.    But one key idea is to think in terms of drawdowns  -- in general, the higher the volatility the higher the drawdown.   What does this mean?   It doesn't mean that volatility is just bad --- it means that with funds like the Russia Fund (RSX) or Brazil (EWZ) or Financial stocks (XLF), your TIMING is more important than with something like a consumer staples ETF (XLP) or an investment grade bond fund (CIU).    Since we've posted this many times this year, it's time to take a look at some actual hard data through the first 11 months of 2010.

The chart below compares the known volatility exiting 2009 with the subsequent drawdown in 2010.   We think this shows the basic idea pretty well.   Its certainly not going to be exact --- but in general, it makes sense.   So we can think about this from a higher level to help us.   If our portfolio were 100% long Brazil (EWZ) all year, then the portfolio value would have moved down -24.7% off its high at one point.   You didn't 'lose' -24.7% vs your starting cost   ---   but you did lose a big % off the high.    A goal in portfolio management is to smooth out the ride a bit.  

Note here that this is just one 11-month period of data.  The concept is solid -- but the future will be different.     The S&P 500 had a -15.6% drawdown during this particular period.  Less volatile ETFs all had lower drawdowns. A few on this list that had significantly higher volatilities had lower drawdowns --- but not by much.   This is for concept and its relative.   If the S&P 500 has a larger drawdown next year, then expect these numbers to all be bigger when we do this again next year.

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You hear the term ‘volatility’ thrown around a lot but it is really not well understood outside of the options market community.  Ask people outside the options community how to calculate volatility and they will likely stutter (including professional advisors).  

Using a chart in combination with volatility can visually show the important link between volatility and ‘drawdown.’  This chart looks at a simple comparison between the Barclays Aggregate Bond Index, the S&P 500 and the ProShares 2x Leveraged Long S&P 500 ETF.

In this case, we know that the ProShares fund has exactly 2x the daily volatility of the S&P by design and so we expect it to have 2x the daily volatility, by definition (excluding tracking error and any expense ratio differences – which are usually trivial).    

But we would like to take this one step further -- as you observe various indexes, you can and should use the relative volatility of any ETF as a general guide to how much it may lose relative to the market in a correction.  It’s not that the precise historical volatility figure will predict the future volatility, it won’t.   But the historical volatility will offer a very good estimate of the RELATIVE size of a correction vs something like the S&P 500.

It’s a good rule to remember: the higher the volatility, the higher the drawdown.   If you buy and hold the most volatile ETFs, it’s just a matter of time before you will face a significant drawdown.   

Below is a chart that replaces the ProShares 2x ETF with an unlevered fund:  the very popular Brazil fund (EWZ).   

Note the extremely high relative volatility --- and the larger drawdown.  If I graph volatility historically, you will see that in every observed instance, EWZ is materially more volatile than the S&P 500.   This does not by itself make EWZ unattractive – it depends on your return forecast for EWZ.   Should your return forecast for EWZ justify the increased volatility, then this is good news -- you would own it.

Summary:  the securities with the highest marginal contribution to portfolio risk should provide the highest expected returns.  This entirely logical concept tells the portfolio manager if their portfolio positioning is consistent with their own beliefs.

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One of the major benefits of exchange traded funds is that they provide greater precision in allocating risk. ETFreplay.com has intentionally built virtually every one of our website pages with risk/volatility in mind.  When we designed the layout, we felt that volatility should not be an indicator in the lower pane of a charting layout – it is too important – so we created an ETF Charts layout that deliberately puts the 2 main components of the Sharpe Ratio in the upper pane.    We do this because for sophisticated investors:  discussing returns without the context of risk is meaningless.

One interesting way to appreciate the Sharpe Ratio is to show how it cannot be fooled by something like the ProShares leveraged index ETFs.  This is a useful exercise as the nature of compounded returns is actually quite a bit more complex than it seems.  

SSO is the 2x leveraged long S&P 500 ETF.  By construction, it will always have 2x the volatility as the S&P 500 --- but as you look past the short-run, only in the very best case scenario will it equal 2x the daily mean return of the S&P 500.    

It is possible that leveraged ETFs can have roughly equal Sharpe ratios vs the unlevered ETF --- but never more --- and very often much worse.   The compounding of returns over time is the killer -- only in the case of a non-stop upward move will the sharpe ratio be approximately equal.   The nature of compounding is that large losses are disproportionately hard to make up in a rally while outperformance can be quite easy to give up in a correction if you are not careful on watching volatility.

From an investors perspective  – the leveraged products are flawed.  We will spare the reader the math on this and instead show the very dramatic leveraged ETF charts as a more extreme example of how important it is to avoid high volatility ETF’s when they do not have relative strength – the losses are just too great.   The converse of this is that by focusing on the Sharpe Ratio for your portfolio (intentionally reducing volatility when there is no relative strength), you stand at a distinct advantage of benefitting from the likely long-term outcome of markets that don’t just forever run up in non-stop fashion:

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Volatility spiked on April 27th, lets take a closer look.

First note that while the S&P 500 dropped -2.0%, the higher volatility ETF's are in steeper drawdowns:

What performed well? The usual suspects --- those with negative correlations to equities, including the VIX ETF's, the inverse ETFs from ProShares, long duration US treasuries, precious metals, the U.S. Dollar and the Japanese Yen.

The last chart goes back to focus on U.S. Sector SPDR ETF's. Note again that those with higher volatilities led to largest drawdowns.

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Lately I have read in a few places that "investors too often equate risk with volatility." The people who say these kinds of things rarely go on to present an argument based in statistical fact. This blog post is not to say anything is absolute --- but I will show some simple recent data that hardly refutes the statement put forth on the first page of Chapter 3 in ‘the bible’ of quantitative finance ‘Active Portfolio Management’ (Grinold & Kahn, 1999): – it could not be much clearer: “Risk is the standard deviation of return.”

Below is data from the past bear market for 5 of the largest ETF’s in the world. I have chosen to use the standard deviation of the period PRIOR to 2008, Q4 2007. I then show the subsequent drawdown in 2008. Note how in each case of higher standard deviation, the drawdown was larger in the NEXT period.

While the above is just a sample --- I can show this over many, many more ETF's. Thinking about your portfolio from the viewpoint of standard deviation can help you understand at least in some small way about how your portfolio might drawdown relative to some common benchmarks. This chart shows volatilities across these same 5 ETF's over time. Note that each ETF has held its relative position for the past 3 years -- zero change. While you cannot know with precision what the future holds -- you can to some extent understand your relative drawdown given S&P volatility of XX.

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In the world of hedge funds, it is standard practice to list a ‘volatility target’ within a presentation to potential investors. You never see this listed in any mutual fund or investment advisor type of presentation. Nevertheless, whether it’s in the presentation or not, it’s a topic that is important to post about as often as possible.

First, volatility is a good way to think about ‘drawdown potential.’ High volatility means that the high to low intermediate moves are likely to be large – and since you can never be quite sure what the future will bring, you should generally avoid the highest volatility ETFs unless you feel especially confident in a high return expectation. The relationship between your general return expectation and the underlying volatility of the ETF is an important one.

What hedge funds state in their presentations is a ‘volatility range’ to expect – that is, what the hedge fund manager believes their strategy equates to in a bottom-line percentage, always stated as an annual figure. Many presentations then try to target a ratio of returns relative to that volatility figure. Two such examples are listed here:

Target: <15% Volatility with >15% Return

Target: 8-12% Volatility with 1.5x+ Return

Both of the above examples from actual hedge-fund marketing books are stated within the same structure: namely, the Sharpe Ratio. Return and volatility of return are both used as quantitative targets.

How does this apply to ETF’s? Each ETF has its own same characteristics. Viewing total return and annualized volatility for each ETF is a nice breakdown of the major components of the Sharpe Ratio. Moreover, you can COMBINE ETF's into portfolios that suit your own risk tolerance.

One major issue for all investors is that volatility is not static. Large changes in market volatility complicate the discussion of absolute targets of volatility. But what we can observe from actual experience is that RELATIVE volatility across different types of ETFs have been quite consistent. Below is an example of a few different types of ETFs. You can see that while the LEVEL has swung around significantly, if we were to rank each of these ETF’s – you would see that each ETF has maintained its exact ranking for every period for the last few years. Emerging markets have maintained high relative volatility vs the S&P 500, which has been more volatile than the defensive Consumer Staples Sector SPDR which in turn has been more volatile than the aggregate bond market.

What this says is that the risk of drawdown among these different ETF’s is skewed. We cannot precisely say what kind of risk there is --- but we can think that if we entered a long position in bonds and mis-timed the entry, the punishment for being wrong would not be as great as if we did the same thing in Emerging Markets.
Summary:

It is professional to think in terms of volatility and risk-adjusted returns. But you do not need to be a ‘long-short’ hedge fund manager to maintain an efficient (risk-adjusted) portfolio. Overall portfolio volatility can be diluted through exposure to shorter-term fixed income. Indeed, rotating between high returning ETF segments (high relative strength) and low-volatility investments is a strategy that generally leads to the same place hedge funds are ultimately targeting: a high Sharpe Ratio.

Note: The Sharpe Ratio measures reward per unit of risk. It is calculated as the annualized average daily excess return divided by the standard deviation of daily excess return.

Examples of the statistical risk-profiles of the S&P 500 and the Aggregate Bond Market (AGG). I have added the 2x Leveraged S&P 500 ETF as an example of going the wrong direction. The goal is to create a portfolio with low standard deviation and relatively high returns. Sound familiar? Yes, these are the core components of the sharpe ratio. The S&P 500 has never had an attractive sharpe ratio.

This particular ETF, Barclays 3-7 Year Treasury Bond ETF (symbol IEI) with a stated effective duration of approximately 4.5 years, had daily standard deviation of 5.5% in 2009. While yields on treasuries are low -- duration management below 5 years is inherently low relative risk.