Choose Your “Perfect” Risk Model
I start with a hypothetical. You are considering between three portfolios A, B, and C. If you could know with certainty one of the following annual risk measures, which would you choose:
- Max Drawdown
For me the choice is obvious: max drawdown. Variance and semi-variance are deliberately decoupled from return. In fact, we often say variance as short-hand for mean-return variance. Similarly, semi-variance is short-hand for mean-return semi-variance. For each variance flavor, mean-returns — average returns — are subtracted from the risk formula. The mathematical bifurcation of risk and return is deliberate.
Max drawdown blends return and risk. This is mathematically untidy — max drawdown and return are non-orthogonal. However, the crystal ball of max drawdown allows choosing the “best” portfolio because it puts a floor on loss. Tautologically the annual loss cannot exceed the annual max drawdown.
My revised answer stretches the rules. If all three portfolios have future max drawdowns of less than 5 percent, then I’d like to know the semi-variances.
Of course there are no infallible crystal balls. Such choices are only hypothetical.
Past variance tends to be reasonably predictive of future variance; past semi-variance tends to predict future semi-variance to a similar degree. However, I have not seen data about the relationship between past and future drawdowns.
Research Opportunities Regarding Max Drawdown
It turns out that there are complications unique to max drawdown minimization that are not present with MVO or semi-variance optimization. However, at Sigma1, we have found some intriguing ways around those early obstacles.
That said, there are other interesting observations about max drawdown optimization:
1) Max drawdown only considers the worst drawdown period; all other risk data is ignored.
2) Unlike V or SV optimization, longer historical periods increase the max drawdown percentage.
3) There is a scarcity of evidence of the degree (or lack) of relationship between past max drawdowns and future.
(#1) can possibly be addressed by using hybrid risk measures such as combined semi-variance and max drawdown measures. (#2) can be addressed by standardizing max drawdowns… a simple standardization would be DDnorm = DD/num_years. Another possibility is DDnorm = DD/sqrt(num_years). (#3) Requires research. Research across different time periods, different countries, different market caps, etc.
Also note that drawdown has many alternative flavors — cumulative drawdown, weighted cumulative drawdown (WCDD), weighted cumulative drawdown over threshold — just to name three.
Semi-Variance Risk Measure Reaching Critical Mass?
The bottom line is that early adopters have embraced semi-variance based optimization and the trend appears to be snowballing. For instance, Morningstar now calculates risk “with an emphasis on downward variation.” I believe that drawdown measures, either stand-alone or hybridized with semi-variance, are the future of post post modern portfolio theory.
Bye PMPT. Time for a Better Name! Contemporary Portfolio Theory?
I recommend starting with the the acronym first. I propose CPT or CAPT. Either could be pronounced as “Capped”. However, CAPT could also be pronounced “Cap T” as distinct from CAPM (“Cap M”). “C” could stand for either Contemporary or Current. And the “A” — Advanced, Alternative — with the first being a bit pretentious, and the latter being more diplomatic. I put my two cents behind CAPT, pronounced “Cap T”; You can figure out what you want the letters to represent. What is your 2 cents? Please leave a comment!
Back to (Contemporary) Risk Measures
I see semi-variance beginning to transition from the early-adopter phase to the early-majority phase. However, my observations may be skewed by the types of interactions Sigma1 Financial invites. I believe that semi-variance optimization will be mainstream in 5 years or less. That is plenty of time for semi-variance optimization companies to flourish. However, we’re also looking for the next next big thing in finance.