Drawdowns Matter, Less Is More
In this memo we pontificate on things that matter most in this type of market and how that can dramatically change the scope of returns for investors. So what matters when it comes to generating Alpha? Drawdowns matter! It takes only one bad drawdown to undo many years of hard work and diligent decision making.
We have learned a lot from some of the market legends, especially in times of crisis whether you sink or swim based on the fundamental principles one holds towards investing.
The above is difficult to juggle with our understanding that one must be different from the market in order to outperform. That means that in generating Alpha you will have periods where your portfolio may go down if you get ahead of market consensus.
We manage this by knowing what we own and having tools that allow us to programmatically hedge our long positions should market conditions require. We like the market being wrong about a specific position so we get a better price. However, if there is a good reason to take risks then hopefully we can miss the tsunamis that cause destruction.
We didn’t adjust our systematic long equities approach until October of 2021. This was after 6 months of R&D into an approach that would allow us to adjust our book accordingly to reflect our appreciation of the market cycle.
Our appreciation of the market over the past 4 years, especially the period 2020 and 2021 has presented us with many lessons that helped establish the foundation for decades of compounding before us going forward.
Context in Previous Memos
This is our third memo. We use memos to help us stress test our thinking while putting a stake in the ground regarding our current views and how we best approach managing assets in a systematic way.
This memo was written warning about the 2020–2021 asset bubble and how there was a high risk of an asset bubble crash and the contribution of inflation even if the long term trend is deflationary.
The purpose of this memo was to muse over the impending correction that was ahead of us coming into 2022 and how we were approaching and navigating this period. So far in practice this has served us extremely well while remaining long growth.
The Maddition Investing Principles vs Medallion Fund and Jim Simons
Lately we have been revising our principles in this game and then we thought it would be fun to compare them to one of the investing GOATS, Jim Simmonds who founded Renaissance Technologies, the best performing hedge fund (Medallion Fund) of all time. Their returns are legendary and they have 300 PhD’s who continually optimise quant-based approaches to beat the markets.
We have always considered ourselves systematic as we use an augmented approach at the convergence of machine and human-based systems. It is our opinion that this should deliver better results over the long term. Only time will tell if we are correct in our assumptions.
Charlie Meaden (Maddition Reflexive Strategy)
- Free to explore
- Play many instruments (equities, bonds, options, commodities)
- Less is more
Jim Simons (Medallion Fund)
- Guided by beauty
- Surround yourself with the smartest people you can
- Don’t run with the pack
- Don’t give up easily
- Hope for good luck
The Maddition Reflexive Mental Model (Strategy Story and Approach)
The Maddition Reflexive Strategy was originally our best interpretation to generate Alpha without betting on illiquid assets. The research took us approximately 18 months to formalise the approach. This was followed by a further 12 months stress testing the strategy manually and now over 2.5 years trading systematically.
The thesis was and remains the same over this period — can we identify liquid assets in emerging investment thematics that the market is struggling to value while avoiding greed and being fully cognisant of impending fear.
We buy what nobody wants and sell where euphoric expectations converge withrealities.
Because we are mere mortals we off-load certain tasks and processes to machines to help us increase our search horizons for misunderstood consensus and to run our book more efficiently.
Our primary interest is in innovation and backtesting validates our thesis that we should put most of our long book into growth equities, specifically small and mid caps.
We effectively blend the above by managing our strategy collating macro economic theses and thematic investment ideas, often searching for bubbles while investing in the aforementioned growth assets.
We strongly believe this differentiates us from many other approaches and this departure from consensus sets us up to always perform differently (S&P and NASDAQ).
We are of the belief that over the long term this will return 45% IRR as has been demonstrated through backtesting and through the overall to-date performance of our strategy. No doubt time will tell whether we can remain aligned to our aspirations.
Why Drawdowns Matter
To set the scene we wanted to demonstrate why drawdowns matter and how avoiding drawdowns could be one of the most important components to a portfolio manager’s track record.
Let’s take a look at the comparison of the QQQ and the QQQ in an alternative universe that forfeits the returns from last year of the Pandemic bull run and as a reward also misses the subsequent market correction. Now we project both forward 5 years based on the the median return of the NASDAQ since 1972 to today of 15.4%:
Reference: Drawdowns Matter Worksheet
This extrapolation returns an astonishing 68% difference between the two over a 12 year period in cumulative returns.
The Pandemic bubble will go down as one of the, if not the greatest, drawdowns in market history. You have seen the two high flying asset classes retreat over 75% in cryptocurrencies and innovation stocks and IPOs (BTC and ARKK). If we were to look back in history, we would observe that there is a good chance that the indexes may follow.
We must confess that we started writing this memo in June where the title was proposed to be So What’s Next?. We found it difficult to get comfortable with some of our writings and drafts as the answer to the question was nothing …. do nothing. We had already spent the time and done the work and it is just a matter of time until it all pans out.
We have done very little this year, with the majority of the work going into hedging out our book since last year resulting in us being up 6.95% year to date. Often we have been tempted to do more, increase our long positions or get extra aggressive on the short side. However we are happy to report that we have remained stoic and found that in this market Less is More.
We are ready to put our capital to work when the time is right. Short positions will be cut extremely quickly as we maintain tight stops on those positions so we can secure our profits.
Market Psyche — I Support the Current Thing
The current thing in markets was work from home and meme stocks during the Pandemic. We then had crypto and NFTs and with the emergence of inflation and the Ukraine war, we see the advent of the commodities super cycle, or at least expectation of from participants and speculators.
The memetic behaviour that markets embody is extremely interesting and has been on full display as market participants have navigated through the last 24 + months. This is more obvious now because of the speed at which markets are now able to operate. An increased volume of assets simultaneously trading across multiple time zones and exchanges enable assets to trade on more information thus creating even greater volatility. What feels like a decade of market events has only been 24 months. This is a trend we currently expect to continue into the future — especially with so many automated systems trading helping to further the current market consensus.
This increased cacophony of noise within markets is now a significant detriment to market participants. Previously retail was at a disadvantage because of a lack of accessible information. Now retail is being bombarded with noise from robots in concert with social media to make short term FOMO-ike theatre.
Markets will not be the current thing for some time as this crash will affect many people who are investing for the first time. Investing in Bitcoin before Saturday Night Live or when it is $60k+ is the antithesis of the current thing. The strategy is to invest before it becomes the current thing and then find a greater fool to buy the asset once it is the current thing.
The Bear Market — Our Current Thing
Doomsday assets; oil will go up forever; Bitcoin is dead; growth stocks will never reach their previous highs and inflation will be something we will fight into the future as far as the eye can see. That is the thing, now that this is the thing we start to get a little more bullish.
Estimating how long a bear market will last seems like a hard task that we are unable to time. What we have though is a view that we are between 25–75% through this bear market and we are looking for deals on the long side. We are marrying that with a view that there are still many more aspects of the current global economy that will break in the midst of the recession and deleveraging we are currently experiencing.
Washing Out The Weak Hands
A bear market will route out market participants that took on too much risk and those who are following investment ideas from others without having the intestinal fortitude it requires to invest effectively.
In our business we often talk about conviction — we get conviction from working through problems from first principles and one of our company principles is to live to trade another day. This tends to help us avoid taking on too much risk on any sequence of trades.
We always cringe when we see signal services or guru’s selling their investment strategies. Not because we judge the validity of the signals or guru’s investment methodologies, but because anyone that follows will not possess the levels of conviction that are required to execute investment strategies properly.
If we don’t have true conviction or need to access our investments tomorrow, we can then easily become a victim to the erratic behaviour of Mr Market.
You never walk into a recession, something will break, there could be another 20% to go for the indexes.
Even though this correction has been relatively orderly at the index level, we are starting to see the cracks of forced liquidations so far in September 2022.
Markets have been spending too much time obsessing over inflation, specifically CPI and are largely overlooking the realities of a full blown recession hitting with the potential of debt crisis or sorts.
Inflation is reflexive in that more and more people change their behaviours as the narrative sets in and the data reconfirms this which then drives more behavioural change that further exacerbates the inflation rhetoric.
Too much inflation means that pricing shocks, demand destruction and central bank intervention to raise interest rates will happen. Once everything is broken they will stimulate and print money.
Pricing shocks mixed with the cost of money going up leads to the books not balancing. Not balancing in the banks, in large enterprises, small businesses and ultimately the consumer. These are all interconnected — an event in one area will lead to consequences in another — fundamentally a house of cards.
It seems to us that the next phase will be all of the above, reducing risk and costs as quickly as possible which is reflexive and will result in headwinds for earnings and potentially more layoffs.
Layoffs coupled with money that is more expensive could result in defaults and bankruptcies. Businesses and consumers who are over leveraged will be hit hardest. This would result in lower inflation.
Our view is that it is likely that something breaks and we go into a recession of some description (perhaps we are already in one). One thing leads to another and we will have an opportunity to buy hand-over fist.
There seems to be the effervescent scent of a generational wealth opportunity looking us in the face if one was to have the right mix of patience and courage over the coming period.
Less is More
The objective this year has been to preserve fund value through this bear market and generate as much cash as possible.
We ended the week (September 30th 2022) as follows:
Our approach at this time:
- Holding some long positions, building where we can (very little activity)
- Generating cash from covered called and cash secured puts
- Increasing cash from trading bear market rallies
- Hedging risk — protecting fund value
- Shorting high conviction investment ideas
This approach has generated significant Alpha for our strategy year to date and ultimately protected our cumulative return since we started in 2019.
Year to Date Performance:
When one acquires a strong conviction about a probable market outcome it can be helpful to imagine based on your knowledge of how assets tend to move in different conditions. This coupled with the nuances of the current environment you can set a number of expected outcomes giving a signal to start getting bullish again.
That was our approach when we adjusted our core strategy one year ago. We had some idea of the pain that would likely unfold so set some critical thresholds that would get hit helping us know when to go short and when to increase long exposure.
Right now we are happy to reduce our short exposure in the short term with some tight stops on open positions. However, we will be increasing long exposure with caution. Our priority remains to minimise drawdown in this period and be ready to get aggressive when the criteria we follow is met.
There are a number of businesses that have been hit hard in this bear market that the prices we can purchase at are becoming interesting.
If we are really like a business and want to start a new position then we may opt into writing cash secured puts for the premiums.
In a full blown bear market it can be hard to know when to try and catch the falling knife. We have found that running a portfolio that is quantitative and systematic in nature allows us to reduce the noise and focus on the most important parts of any thesis or trade. We simply choose metrics and events we want to see that then triggers actions from the team or system. We could with confidence start buying now and it would likely provide profitable returns over the next 2 years. However, not enough things have broken yet, we are close.
As a systematic approach that focuses on growth and innovation we compare and benchmark ourselves against a number of indexes and ETF’s. We have demonstrated far superior returns cumulatively since our inception and year-to-date compared with: ARKK, NASDAQ100, RUSSELL 2000 and S&P. The delta is driven by our ability to slightly outperform in bull runs and avoid a large drawdown in 2022.
Avoiding surprises can be done by understanding how to put on tail-risk and daring to look the charging white rhino’s in the face and moving out of the way. We have made the mistake in a previous trade with some Chinese equities where we got seduced by the relative “value” seen in Chinese equities versus the US and discounted the geopolitical, economic and domestic issues that faced China at that time. Never fall in love with a company, industry or investment thesis.
If we take what is going on with the United Kingdom right now, it is hardly surprising that their currency is down the drain and now they have to intervene in order to avoid a full blown credit crisis. There are no Black Swans, just White Rhino’s charging and in the case of the UK it has been charging at us since before Brexit.
Let’s talk about the other White Rhino in the room, the housing bubble in New Zealand, Australia and Canada. For years we have seen capital flight to these destinations where the systems don’t facilitate long term fixed rate mortgages; interest only loans are popular; high percentage of total mortgages are variable and many participants are negatively geared as they expect to get equity appreciation. We now have interest rates 3 times higher and the number of people eligible to keep the gravy train running has diminished dramatically. We are short the Australian banks in size and have conviction they can’t avoid this meltdown. The models that they have crafted don’t take into account 8+% interest rates, which will result in default rates going up.
At this point, inflation doesn’t really matter. CPI readings are lagging and somewhat irrelevant. We still don’t have confirmation that rate hikes are working or that we have already gone too far and we will shortly see a sharp drop in demand.
We are taking the view that we must position to maintain book value through unexpected breaking events within the financial system. This will be due to institutions being overly encumbered with obligations that they can’t service and there is a possibility we are going to have a debt crisis.
Proceeding these breaking events, all that are too offside will blow up or be bailed out by a larger institution (all the way up to the Fed) at bargain basement prices. By this time we will have completed the unwinding of this cycle and bull market which will be followed by starting to rewind the next one. Cash is a position, be bold and courageous and the number one rule is always, live to trade another day.
One will never outperform the market by just going with the crowd. It can be a tiring exercise to swim against the tide, however, we end with a quote from Charles Bukowski.
“What matters most is how well you walk through the fire”
LEGAL INFORMATION AND DISCLOSURES
This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Maddition has no duty or obligation to update the information contained herein. Further, Maddition makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This memorandum is being made available for informational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Maddition Limited. (“Maddition”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
This memorandum (and previous referenced memoranda), including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Maddition.