Understanding Drawdowns: A Key to Managing Risk and Liquidityin Portfolio Strategy

Investments come with inherent risk and volatility, more so when the underlying is equity. While building a portfolio investors use a core and and satellite approach towards allocation, where the core forms the base (around 60-75% allocation) and is typically a more stable portion of the portfolio, and the satellite portion is built of assets that can generate alpha to increase the overall portfolio return. 

The satellite portion involves taking tactical calls based on expected market movements in the short to mid-termand tends to display high volatility. While it offers the potential for enhanced returns, it also comes with increased risk. One of the critical factors that investors must consider before engaging in tactical allocation is the drawdown of an asset class. A drawdown measures the decline in the value of an investment from its peak to its trough and is a key indicator of the asset's volatility and potential risk.

Understanding drawdowns is essential for investors, particularly those with shorter investment horizons or those employing a core and satellite approach in their portfolios.

Understanding the drawdowns in Tactical Allocation helps an investor in:

1.    Measuring Volatility and Risk: During the 2008 financial crisis, global equities experienced drawdowns exceeding 50%, which took years to recover. An investor who was tactically allocated in equities during this period could have faced significant losses if they were not prepared for such a downturn.

2.    Time to Recovery:The time it takes for an asset to recover from a drawdown is another critical factor. If the time horizon for holding an investment is short and the drawdown is severe, the asset may not recover in time to provide the desired returns.

3.    Impact on Portfolio Performance: In a core and satellite approach, investors often use the satellite portion of their portfolio to seek alpha through tactical allocation. However, a significant drawdown in the satellite portion can negatively impact the overall portfolio performance.

For example, if an investor allocates 25% of their portfolio to a high-risk asset with a potential drawdown of 30%, a market downturn could reduce the portfolio's total value by 7.5% (25% * 30%), even if the core portion remains stable. This drag on performance can be particularly detrimental in a volatile market environment.

Historical Drawdowns of Nifty 50:

Drawdown    Start Date    End Date    Drawdown Period    Days to recover    Recovery Date
-38.43%    14-Jan-20    23-Mar-20    69    165    09-Nov-20
-28.18%    09-Nov-10    20-Dec-11    406    487    31-Oct-13
-21.81%    03-Mar-15    25-Feb-16    359    138    06-Sep-16
-16.62%    18-Oct-21    17-Jun-22    242    105    11-Nov-22
-14.41%    28-Aug-18    26-Oct-18    59    112    02-Apr-19

1.    Covid-19 Market Crash: In March 2020, the COVID-19 pandemic led to a rapid drawdown of around ~39% in the Nifty 50. However, the market rebounded quickly, with the drawdown fully recovered within 8-months. Investors who understood the drawdown risk and remained tactically allocated in equities were able to benefit from the swift recovery.
2.    During the 2010-11 crisis, the Nifty 50 experienced a drawdown of ~28% over a period of 1 year 1 month. The recovery took another 2 years approximately, making it unsuitable for short-term tactical strategies.Investors with tactical allocations in equities suffered significant losses, and many were unable to recover their investments within their intended time frame.

Hence, it is important for an investor to educate themselves about different asset classes, their characteristics, the risks involved, and potential returns before the tactical allocation. Understand the trade-offs between risk and reward.Each asset class has a distinct role in the portfolio.

>  Equity - To build wealth over long-term
>  Debt - For capital preservation and regular income 
>   Gold - Inflation Hedge and Hedge during uncertain times

Historical Drawdowns
Equity & Debt Indices    1 Yr    3 Yr
Nifty 50    -52.2%    -13.8%
Nifty Midcap 100    -59.4%    -12.0%
Nifty Smallcap 100    -71.0%    -19.9%
CCIL T-Bill Index    1.9%    2.5%
NIFTY 5YR G-SEC INDEX    -1.5%    2.9%

Therefore, an investor whose period for holding the investment is low should not invest in an asset class that has high drawdown (like equity), as the asset might take significantly longer to recover. Those investors should park the money in liquid or short-term debt instruments, which are safer and preserve the capital.
Conclusion:
Understanding drawdowns is a critical aspect of risk management in tactical allocation. Investors must consider the potential drawdown of an asset class, the time it takes to recover from a drawdown, and the impact on overall portfolio performance before making tactical decisions.