Misunderstanding of Absolute Returns

In school, I never wanted to be scolded / hit / made to stand on bench by the teacher and while I was never a meritorious boy, I did enough to ensure that I never got on the wrong side. By the time I finished studies, I was sure I wanted to get into business and not a job. Why? Well, you never get scolded by your boss while you can easily (or at least those were the thoughts in those days) make as much or even better by being your own boss.

I read stories of the successful men and women who went to the top starting with not much than a Garage and a few ideas (I don’t remember reading too many Indian Entrepreneur stories). Then again, no one told me that failure was plenty in business and very few actually made it through.

Its been 20 years now since I went on my own and its been a journey of up and down’s and like in markets, have always used the stairs to climb while lady luck (why blame myself) pushed me back through the elevator vault to nearly where I came from (with only experiences to carry forward). On the other hand, the 1 year I did work under some one else was a revelation and a thoroughly enjoyable experience. Talk about getting misled by faulty opinions.

Being a trader I talk with a lot of people and the one common refrain I hear (especially among trend following friends) is that the reason they chose this method over others is their belief that only this method provides them with “Absolute Returns”. But digging a bit deep, it seems for majority of the folks, Absolute Returns = (Strong) Positive Returns regardless of where the market has done.

Much of the literature too tries to showcase how trend followers blew our their competitors in 2008 even as much of the competition just packed up and left. But that is just half the story. Lets start with one of the most famous trend followers and CTA – Dunn Capital Management.

Draft DUNN Information September 2016.xls

Dunn Capital – Equity Curve

 

The chart (Click to Expand) showcases 2 things – the out performance of Dunn Capital over the S&P 500 as well as the major draw-downs it had during the course of the journey. [A note here, Dunn trades more than just S&P 500 and hence the comparison maybe down right faulty]

When one looks at charts such as these, its easy for the mind to assume that we would be more than happy to have similar kind of returns.

But then again, that is due to the visual nature of the chart which leaves out a large part of the information.

Take for example their draw-down of 63% (heart breaking for anyone regardless of how well his previous returns have been) that seems to have been touched in late 2007.

Let me expand on that ย a bit. You are down 63% on your capital (measured from your peak) even as markets have bit a new all time high. While the rest of the world (your friends basically) are partying, you are left wiping up the ashes your system seems to have left behind.

This draw-down started not in 2007 or 2006 or even 2005 but in 2003 / 04. Remember, that was the start of a great bull run that ended in 2008 even in US. Can you really live with that kind of performance number.

I don’t know about you, but I personally would have long died (not financially but due to the emotional hit that such draw-downs create) long before the next peak in my equity curve arose .

When folks talk about “Absolute Returns” they aren’t meaning returns that are different in nature from the S&P. What they mean (in their view) is returns that are positive regardless of the state of the market. In other words, they are looking for the Utopian dream of “Permanent Returns”, something that can be achieved only by the much abused (by market folks) Fixed Deposit.

For long I have been a votary of Trend following and have given talks on the same to showcase why people should give a thought to this kind of strategy. But the question that I hadn’t focused was whether it was suitable to everyone I preached. An even more important question I left asking (to myself) was whether I was willing to take the pain of short term draw-downs and be able to live with it.

Most trading systems I have come across don’t beat market returns (if you measure / compare correctly). They do beat over short to medium time frames, but over the long term, very few are able to consistently beat and compound the returns.

For many, the way out is to leverage. If your system generates say 10%ย vs Nifty move of 12%, a leverage of 3 times should provide you with 30% returns. Easy right? But then again, draw-downs are thrice what your historical draw-downs will be and given the fact that leverage means paying up the margin / marked to market losses means that the risk is that rather than seeing yourself with 3x returns, you will have a much higher probability of seeing your capital deplete by 65% or even more.

“Bulls make money, bears make money, pigs get slaughtered” is an old Wall Street saying that warns investors against excessive greed. As traders, I wonder whether we ever think that we could be the pigs (majority of us since few will always be there with mind boggling returns). Food for thought, eh?

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6 Responses

  1. rohiniglobal says:

    I will hope mi50 proves ur premise wrong ๐Ÿ˜‰ in the long term..

  2. ajayrajaram says:

    i thought traders worked with a stop loss ? – i don’t believe any trader will sit quiet till a 63% drawdown

  3. Shan says:

    brilliant post as usual! Faced quite a few whipsaws recently, this post has helped me in holding tight ๐Ÿ™‚

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