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Averaging Expectations

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Making Sense Out of Upside/Downside Capture Metrics

It can be dis­cour­ag­ing when an active manager’s short-term up cap­ture isn’t on par with their long-term up cap­ture. But this is a side effect of the mea­sur­ing and using aver­ages for risk/return met­rics, returns, and the like. Aver­ages nat­u­ral­ly mask indi­vid­ual dis­crep­an­cies and may pro­duce mis­lead­ing expec­ta­tions. While aver­ages are use­ful, it is impor­tant to remem­ber their lim­i­ta­tions.


How Averages Obscure Details

Let’s take a look at how aver­ages can mask indi­vid­ual vari­a­tions by look­ing at the S&P 500. Between 1971 and 2017, the S&P 500 aver­aged an annu­al return of 10.68%. Across those 47 years, there was only one year that had a return near the aver­age 10.68% return: In 2004, the S&P 500 had a return of 10.88%. In fact, there were only three years out of those 47 where the S&P 500 was with­in +/- 2% of its long-term aver­age. In that span, the high­est return was +37.58% (1995) and the low­est was -37.00% (2008). Indi­vid­ual year returns fell far and wide between those two book­ends.

An aver­age return is just that—an aver­age. Inevitably some num­bers will be high­er, and some will be low­er. Even though the S&P 500 aver­aged a return of 10.68% between 1971 and 2017, that peri­od expe­ri­enced indi­vid­ual years that were extreme­ly high, like in 1995, or extreme­ly low, like in 2008. Some­one expect­ing a 10.68% return dur­ing 2008 would have been very upset. But over time, the num­bers aver­age out.

While many peo­ple under­stand the idea that returns in an indi­vid­ual peri­od will dif­fer from their long-term aver­age, it is impor­tant to remem­ber that the con­cept of aver­ages extends to most risk and return met­rics as well. Mea­sure­ments like up/down cap­ture will fluc­tu­ate in the imme­di­ate short term as a mea­sure in any one giv­en peri­od is like­ly to be high­er or low­er than its long-term aver­age.

While in the short-term up/down cap­ture can give you an idea about a manager’s month­ly or quar­ter­ly per­for­mance, the mea­sure is much more use­ful over longer peri­ods of time.


Averages & Expectations

Extend­ing the con­cept of aver­ages, it would be a mis­take to assume that a manager’s quar­ter­ly up/down cap­ture will remain the same every quar­ter.

For exam­ple, let’s look at the up/down cap­ture of the Defined Risk Strat­e­gy (DRS). Between July 1997 and Decem­ber 2017, the quar­ter­ly up cap­ture of the DRS has been 52.5% and the quar­ter­ly down cap­ture has been 13.0%. Dur­ing the same span for the S&P 500, there have been 58 up quar­ters and 24 down quar­ters. Sort­ed from worst-to-best, the 82 quar­ter­ly returns of the S&P 500 since July 1997 look like this:

S&P 500 Quarterly Numbers - Swan Blog - Averaging Expectations

Source: Zephyr StyleAD­VI­SOR, Swan Glob­al Invest­ments

If the DRS nev­er devi­at­ed from its aver­age cap­ture ratios and always par­tic­i­pat­ed in 52.5% of every up quar­ter and 13.0% of every down quar­ter, the returns of the DRS would look like this:

DRS Theoretical UpDown Capture Quarterly Numbers - Swan Blog - Averaging Expectations

Source: Zephyr StyleAD­VI­SOR, Swan Glob­al Invest­ments

While the con­sis­ten­cy and pre­dictabil­i­ty of the mea­sure­ment look clean­er, the real­i­ty of the sit­u­a­tion is much less tidy.


Averages aren’t a Guarantee & Deviations aren’t Always Bad

Just like any one year’s return tends to devi­ate far from its long-term aver­age, so do the cap­ture ratios in any one quar­ter. The chart below illus­trates how the DRS’s actu­al quar­ter­ly returns com­pare to those of the S&P 500:

DRS Actual UpDown Capture Quarterly Numbers - Swan Blog - Averaging Expectations

Source: Zephyr StyleAD­VI­SOR, Swan Glob­al Invest­ments

As the graph shows, indi­vid­ual dis­crep­an­cies can hap­pen often. Some­times the DRS cap­tures much more than 52.5% of an up quar­ter, some­times much less. Some­times the DRS cap­tures more than 13.0% of a down quar­ter, some­times less. Despite the dis­crep­an­cies, the long-term up/down cap­ture aver­ages to 52.5% on the upside and 13.0% on the down­side.


Quarterly Comparisons & Consistent Patterns

One way to bet­ter under­stand the indi­vid­ual quar­ter­ly dis­per­sions is to com­pare the indi­vid­ual quar­ters. The table below high­lights the five biggest quar­ters of out­per­for­mance and under­per­for­mance ver­sus the S&P 500:

DRS Up/Down Capture Out&Under Performance Table - Swan Blog - Averaging Expectations

Source: Swan Glob­al Invest­ments

There are two pri­ma­ry take­aways from this table.

First, the peri­ods of the great­est out­per­for­mance tend to hap­pen dur­ing major, dou­ble-dig­it sell-offs and the largest under­per­for­mance tends to hap­pen dur­ing large, dou­ble-dig­it ral­lies. Even though there are indi­vid­ual diver­gences, this pat­tern demon­strates that the DRS con­sis­tent­ly per­forms the way it is intend­ed.

Sec­ond, many of the peri­ods of large dis­per­sions hap­pened ear­ly on in the DRS’s his­to­ry. Eight of the ten biggest quar­ter­ly dis­per­sions occurred with­in the first sev­en years of the DRS and none have occurred with­in the last five years. The DRS has evolved over the years with one of the goals being to reduce peri­ods of huge dis­per­sions, which it has been able to do.


Don’t Forget the Down Capture

The down cap­tures are worth explor­ing in more detail because the con­text in which these cap­ture ratios occurred sheds light on the results.

In the graphs below we see the rolling, five-year quar­ter­ly cap­ture ratios, with up cap­ture on the top and down cap­ture on the bot­tom. You can see that on a rolling five-year basis the up cap­tures range from 19.35% to 78.57% and the down cap­tures range from -57.36% to 72.19%. It is impor­tant to remem­ber that the low­er the down cap­ture, the bet­ter; a neg­a­tive down cap­ture indi­cates that the per­for­mance of the DRS was pos­i­tive when the mar­ket was los­ing mon­ey.

DRS Up/Down Capture vs Benchmark - Swan Blog - Averaging Expectations

Source: Zephyr StyleAD­VI­SOR, Swan Glob­al Invest­ments

The point when down cap­ture was at its best was the five- year peri­od end­ing Decem­ber 2007. This span includ­ed the tail end of the dot-com cri­sis and the start of the Glob­al Finan­cial Cri­sis. The point of the worst down cap­ture is the cur­rent five-year peri­od, end­ing Decem­ber 31st, 2017. At this point, the bull mar­ket is almost nine years old. With­in the last five years, only one quar­ter out of 20, the third quar­ter of 2015, was neg­a­tive. The down cap­ture of 72.19% rep­re­sents only one data point.


Focusing on the Long Game

In a way, this is a man­i­fes­ta­tion of the behav­ior of the DRS described in a pre­vi­ous blog post, “How Some Man­agers Walk the Line.” The DRS does not have a lin­ear rela­tion­ship with the mar­ket. The whole point of the DRS is to not track the mar­ket. This will inevitably lead to return pat­terns that are less dri­ven by the S&P 500.

It is the goal of the DRS to pro­duce a much more sta­ble, pre­dictable range of returns. This was dis­cussed in depth in the blog post “The Impor­tance and Val­ue of a Non-Nor­mal Dis­tri­b­u­tion of Returns.” The trade-off for pro­tec­tion on the down­side is giv­ing up some of the upside.  With a his­toric cap­ture ratio of 52.5% on the upside and 13.0% on the down­side, the DRS has achieved that. How­ev­er, it is impor­tant to remem­ber those ratios can and will fluc­tu­ate over short­er peri­ods of time.



About the Author:

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.




Impor­tant Notes and Dis­clo­sures:

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or 030-SGI-011818


By |2018-10-02T11:01:35+00:00January 18th, 2018|Blog|Comments Off on Averaging Expectations