Face-ripping Drawdowns and the Magic Formula

Face-ripping Drawdowns and the Magic Formula

November 4, 2014 Research Insights, Value Investing Research, Tactical Asset Allocation Research
Print Friendly
(Last Updated On: March 15, 2015)

Due to a surge of interest from our “Long Cheap; Short Expensive. Buyer Beware” post, we decided to analyze the impact of changing the net exposure of the Magic Formula Long/Short portfolio (and of course, the impact on returns). Similar to the last post, the portfolios are formed as follows:

  • Variable 1: EBIT/TEV (Total enterprise value)
  • Variable 2: EBIT/Total capital

To exclude smaller firms, we eliminate all listings below the NYSE 40th percentile, which was around $1.95 billion on 12/31/2013. On 12/31/13, this leaves a universe of ~1050 firms. We then rank the firms on the two variables and form quintiles of average rank of quality and price. The quintile portfolios are formed on 6/30 each year, held for a year, and equal-weighted. All returns are total returns and include the reinvestment of distributions (e.g., dividends). We buy the top quintile (~200 firms) with varying exposure (e.g., 175% long, 75% short, 125% long, 75% short, etc.), go short the bottom quintile (varying exposure), assume a management fee of 2.00%, and a short rebate of 0.25%. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Here are the returns from 1/1/1960-12/31/2013:

2014-11-03 13_47_50-Microsoft Excel - MF long short analysis v01.xlsm
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

A few things worth noting:

  1. “Net” exposures vary from 100% to 50% to 0%.
  2. CAGR drops from 16.22% to 11.83% to 7.81% as net exposures drop from 100% to 50% to 0%.
  3. Correlation to S&P 500 drops from 67.12% to 41.04% to -22.80% as net exposures drop from 100% to 50% to 0%.
  4. Maximum drawdowns are large across the three strategies, from -59.86% to -71.01% when varying exposures from 100% to 50% to 0%.

The list of drawdowns are in the table below (click to enlarge).

drawdown
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

All drawdowns are anchored off the market neutral version of the strategy (i.e., we stack rank market neutral drawdowns, and then compare what happened across other mixes of exposures. As we pointed out in our last research post, going long cheap and short expensive is dangerous to your wealth. If you are long value and short growth, and the market has an internet bubble, where growth just gets more and more expensive relative to value, you are going to have a bad time. The markets can–and do–remain irrational longer than you can remain solvent.

Is there a way to improve the Long Cheap/Short Expensive strategy?

One suggestion would be to go the cheaper route, and form a DIY hedge portfolio, as opposed to paying 2% management fees. Build your DIY hedge fund by going long the top quintile of cheap names (varying exposure) and shorting the SP500 (varying exposure). We assume a 0.25%+- funding spread over t and a 0.20% annual transaction cost, as we only need to rebalance the long portfolio annually, and shorting with a SP500 future has minimal costs. Here are the returns from 1/1/1960-12/31/2013:

2014-11-03 13_57_46-Microsoft Excel - MF long short analysis v01.xlsm
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

A few things worth noting:

  1. “Net” exposures vary from 100% to 50% to 0%.
  2. CAGR drops from 16.64% to 12.57% to 8.70% as net exposures drop from 100% to 50% to 0%.
  3. Correlation to S&P 500 drops from 77.55% to 66.12% to 6.95% as net exposures drop from 100% to 50% to 0%.
  4. Maximum drawdowns decrease as net exposure decreases. These go from -58.08% to -35.04% to -27.29% when varying exposures from 100% to 50% to 0%.

Comparing this DIY approach to the Magic Formula Long/Short strategy, it appears that if someone wanted a “hedged” exposure to value, shorting with S&P 500 would have help to limit drawdowns. Hedging with S&P is safer than hedging with expensive stocks, when growth stocks are raging higher in an internet bubble. The drawdowns when hedging with S&P 500 are lower in all three net exposure portfolios. Additionally, hedging with S&P 500 can be done fairly simply via futures and ETFs.

Overall, the DIY approach may be interesting if an investor is concerned about market exposure.


Note: This site provides no information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.


Join thousands of other readers and subscribe to our blog.


Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.




About the Author

Jack Vogel, Ph.D.

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  • Bryan

    I’m posting this a bit late as it’s about your earlier post on Gotham’s long/short Funds. Like you, I was surprised when Joel Greenblatt introduced the long/short funds using what looked like the Magic Formula as he had previously said in his book The Big Secret for the Small Investor that at certain times a long short approach using the formula would have led to horrific draw-downs.

    As you suggest, Greenblatt appears to be one of the good guys – his investment track record, his books, the lectures at Columbia and his general demeanor attests to that. So I think we have to assume that since he published the The Big Secret he has found a way of making the short portfolios work better. One thing that has changed from the magic formula days is that he no longer equal weights the holdings but value weights them so that the cheapest (and most expensive) stocks are the largest positions long (and short).

    Thank you for your excellent blog

  • Jack Vogel, PhD

    Thanks. In our opinion finding a great short book (that does not cause large drawdowns) is extremely difficult. Maybe they figured it out, but time will tell.

  • Adam Kearny

    Hi Jack, Thanks for the analysis. My sense is that your back-tests are overly simplistic as they omit a number of critical factors in the Gotham Funds’ long-short strategies and thus present an exaggerated impression of the risks involved in these types of strategies. For example, there is no indication that your back-testing uses sector caps or individual name stop-losses (all diversified market neutral strategies use sector caps–see AQR, Gotham, Boston Partners, etc.). I suspect that the enormous short-book losses in your 1998-2000 back-test involved most (or all?) of the portfolio being concentrated in tech names. That would never happen in any of these real-life funds. Also, much of this discussion in these threads is theoretical as though long-short value funds are an untested new invention. BPLSX has been around for 18 years and was launched in 1998 and was market neutral (25% net long and organized around value and quality factors) throughout the tech bubble. The fund delivered a return of -12.8% in 1999 followed by +60% in 2000 and +25% in 2001. Nowhere close to the 70%+ wipe-out you suggest (I know, they’re not exactly “magic formula”, but it’s a very similar to Gotham’s approach (perhaps demonstrates in real-time the power of sector caps and stop-losses?), and the past couple years, they’ve tended to loosely track Gotham’s market neutral fund). Cliff Asness at AQR (about the smartest quant guy on the planet) has in interviews also vouched for the “diversified long cheap, short expensive” as being a well-tested, historically effective strategy both in US markets and globally. Finally, your back-tests suggest large draw-downs during “dash-to-trash” periods coming out of the last two bear markets (i.e. 2009-10). Gotham has been running these strategies in hedge fund form since 2009, and I know for a fact that they actually crushed it in 2009-10, so your back-tests clearly do not reflect what they are actually doing in their funds (not even close).

  • Adam Kearny

    It can’t be that difficult if you match exposures carefully and continually monitor and adjust. I think the key is avoiding unintentional systematic exposure to anything other than value/quality (sector exposure, beta, macro factors, etc.). I noticed in reviewing Gotham’s filings that there seems to be very close matching of the long and short book. Interestingly though, their short book is causing some modest losses in their funds so far this year. Theoretically, it’s possible to have a world-ending draw-down in anyone’s diversified short-book, but historically, the only people to suffer from crushing draw-downs (as opposed to Julian Robertson’s 1999-2000 “teens” draw-down that scared off his investors or BPLSX’s 13% draw-down in 1999) from short-selling are those with concentrated short books who don’t manage risk.

  • dph

    Adam,

    You make some good points. Can you suggest other funds ( or ETFs…) that are doing similar long/ short and manage their short side similar to what Gotham is doing?

  • Adam, curious to get your take on the -10% YTD performance on the Gotham Market Neutral Funds. Is the system broken or is this just noise? Interested to hear your thoughts.

  • Adam Kearny

    My sense is that this year has been classic end-stage bull market action–a very narrow advance concentrated in speculative “growth stocks” particularly small-caps. You can see this by comparing the performance of IWO (small-cap growth) to other indices including IWN (small-cap value). This sort of massive divergence (compare IWO to IWN over the past 5 years), which has really blown out this year, is historically unsustainable and will at some point close in dramatic fashion.
    I also note that BPLSX, which went down -12.8% in 1999 before doubling over the next two years, is also down this year, and Einhorn (who went 20% net long/market neutral a couple of months ago) had an even worse June than GONIX (he declined 4.3% in June). John Hempton at Bronte Capital has made similar observations on short-biased funds getting beaten up this year and noted that “nonsense is widespread” (with respect to bubble/hope stocks). So, I would say that it’s not a Gotham-specific problem–just a 1999-style environment (note that 2007 also had growth stocks trouncing value) that is likely nearing a major top (if the top is not already in), and Gotham funds are only down high single-digits. Cost-of-capital has already started rising which should mark the end of outperformance by the spec garbage in the short book.
    I would expect a period of breathtaking outperformance to hit funds like GONIX and BPLSX at some point once the market tone changes. We got a small taste of that earlier in the week.
    Incidentally, long-only strategies have their own theoretical risk. History suggests that stocks can get slammed to the tune of 60-90% from a speculative peak and stay down for decades (see 1929-1954 USA; Japan 1990-present). If we ever get some type of currency/interest-rate reset, you may never again see the market multiples the market currently enjoys (i.e. we’ll get a permanent re-rating downwards, and “value” stocks, which are currently not cheap in absolute terms unlike in 1999, will not be spared). No strategy is risk-free, but severe bear markets from current levels are far more common than further extensions of the mania–pick your poison.