08/18/15

Three years ago I wondered what a chart of Ed Easterling's monthly up/down capture ratio strategy for matching the S&P 500 return in "Rowing vs. The Rollercoaster" would look like for the period January 1950 to April 2012. After creating the chart I realized that while a 30% monthly up-capture ratio and 0% monthly down-capture ratio produced a very low volatility strategy, it had the bad habit of underperforming the market for years at a time and sometimes for decades.

I then decided to see what charts of the up/down capture ratios would look like that would match the average bull market for various rates of return. This then led to charts representing five different monthly up/down capture ratio strategies.

Please remember, this is all theoretical — in practice, trying to carry out the various strategies is something completely different. They are only meant to be representations of various investment philosophies.

MATCH AVERAGE BULL MARKET RETURNS (click here)
The solid red line represents the up/down capture ratios of S&P 500 monthly returns required to match the average returns of eleven bull markets between January 1950 and April 2012. The monthly up/down capture ratios above and to the right of the solid red line would have exceeded the average of the eleven bull markets and the monthly up/down capture ratios below and to the left of the solid red line would not.

Unless you had a long term rate of return in excess of 13.7%, trying to match or exceed the average returns of the eleven bull markets would have resulted in losing money during the average bear market. This does not mean that if you had a long-term return in excess of 13.7% you would have automatically matched the average bull market and then broke even during the average bear market — it means that you only would have had the possibility of doing so. A long term rate of return below 13.7% definitely meant you would not have been able to match the average returns of the eleven bull markets without losing money during the average bear market.

MATCH ALL BULL MARKET RETURNS (click here)
The dashed red line represents the up/down capture ratios of S&P 500 monthly returns required to match all the returns of eleven bull markets between January 1950 and April 2012. The monthly up/down capture ratios above and to the right of the dashed red line would have exceeded all of the eleven bull markets and the monthly up/down capture ratios below and to the left of the dashed red line would not.

Unless you had a long-term rate of return in excess of 16.2%, trying to match or exceed the returns of all eleven bull markets would have resulted in losing money in the average bear market. This does not mean that if you had a return in excess of 16.2% you would have automatically matched or exceeded all the eleven bull market returns while breaking even in the average bear market — it means that you only would have had the possibility of doing so. A long term rate of return below 16.2% definitely meant you would not have been able to match or exceed the returns of all eleven bull markets without losing money in the average bear market.

BREAK EVEN IN AVERAGE BEAR MARKET (click here)
The dashed gray line represents the up/down capture ratios of S&P 500 monthly returns required to break even on average in ten bear markets between January 1950 and April 2012. The monthly up/down capture ratios above the dashed gray line would have made a positive return on average in all of the ten bear markets and the monthly up/down capture ratios below the dashed gray line would not.

It is possible to break even over the full bear market while capturing some of the down-months' negative return because you are capturing some of the positive return of the bear market's up months (an exception was 1987 when there were 3 months of down and no up). This is a much better strategy than the two strategies mentioned above in that it produces less of a roller-coaster ride.

If you had a long term rate of return less than 13.7% you would have underperformed the average bull market but at least you had the possibility of breaking even on average in the ten bear markets. It would take a long-term rate of return above 13.7% to be able to match or outperform the average bull market while breaking even on average in the ten bear markets. This does not mean if you had a return over 13.7% you would have automatically been able to match or outperform the average bull market while breaking even on average during the ten bear markets, only that you had the possibility of doing so.

LOW VOLATILITY CAPTURE RATIOS (click here)
This is "theoretically" the best strategy. The dashed orange line represents the up/down capture ratios of S&P 500 monthly returns that would have produced the lowest volatility from January 1950 to April 2012, while the monthly up/down capture ratios above and below the dashed orange line would have produced higher volatility.

Not only did these monthly up/down capture ratios along the dashed orange line produce the lowest volatility, there was also no drawdown. The only problem with this strategy is that it underperforms in bull markets more than almost any other strategy while producing unnecessary high excess returns in bear markets.

I say "unnecessary" since just breaking even in a bear market is more than sufficient for most investors and to make a modest positive return in a bear market would be considered a major achievement. It is totally unnecessary to make high returns in a bear market if it is at the expense of severely underperforming in a bull market.

0% MONTHLY DOWN CAPTURE (click here)
"In practice" I believe that the white horizontal line at the 0% down-capture ratio of S&P 500 monthly returns represents the best strategy (see Ed Easterling's "Rowing vs. The Rollercoaster"). It performs better than the low volatility strategy in bull markets while producing decent returns in bear markets. While the volatility is a bit higher than the low volatility strategy, of more importance is the fact that there is no drawdown (see Hedge Strategy). Quite frankly being able to break even in down-months and capture some of the up-months' return is the Holy Grail of long/short equity investing.

If you had a long-term rate of return in excess of 15.1% you would have been able to match or exceed the average returns of eleven bull markets between January 1950 and April 2012 with 0% monthly down-capture. This does not mean that if you had a return in excess of 15.1% you would have automatically matched the average of the eleven bull market returns, only that you would have had the possibility of doing so. A long-term rate of return below 15.1% definitely meant you would not have been able to match the average returns of the eleven bull markets even if you were breaking even in down-months.

It would have required a long-term rate of return in excess of 18.5% to have matched or exceeded all the returns of eleven bull markets between January 1950 and April 2012 with 0% monthly down-capture. This does not mean that if you had a return in excess of 18.5% you would have automatically matched or exceeded the returns of all eleven bull markets, only that you would have had the possibility of doing so. A long-term rate of return below 18.5% definitely meant you would not have been able to match the returns of all eleven bull markets even if you were breaking even in down-months.