1/8 Asset Management / May 2019
For institutional investors only / not for public viewing or distribution
Drawdown management
strategies – preparing for
the next market downturn
Multi Asset Boutique –
Alternatives & Multi Manager Solutions
So-called trading strategies, encom-
passing global macro and commodity
trading advisor (CTA) hedge funds,
faced stiff headwinds after an unprece-
dented flood of global monetary stim-
ulus followed the Great Financial Crisis
of 2008 and the ensuing Euro Crisis.
Central bank actions frequently inter-
rupted trends and created whipsawing
prices. Global macro and CTAs are
the only major hedge fund strategies
showing positive bear-market perfor-
mance, positive convexity and the ability
to take sizable short positions. These
strategies surf capably in rough waters.
All drawdowns are not alike – an introduction
After equity markets corrected between October and
December 2018, interrupting the soon-to-be longest
bull market in history, investors are increasingly looking
for portfolio building blocks that provide protection
or a degree of diversification in drawdowns in order to
mitigate the negative impact these drawdowns have
for investors. Drawdowns can occur in all asset classes,
but since equities tend to be the riskiest asset class
in the portfolios of most institutional investors and thus
have the biggest loss potential, we will focus on equity
drawdowns hereafter. Moreover, while some investors
might already consider equity corrections in the 5 % range
“drawdowns,” we argue that the loss-threshold for a
drawdown definition should be in the –15 % to –20 % range
in order to focus on the occasional but painful events.
Considering the recent Q4 2018 sell-off and the ensuing
recovery, we also hold that the length and path of a
correction are important for the drawdown definition.
The examples in Chart 1 show that the definition of a
drawdown is not straightforward; individual drawdowns
differ in various parameters and are not easily classifiable.
Chart 1 and Table 1, which show all periods with peak-
to-trough losses of more than 20 % of the S&P 500 Price
Index (daily data since 1925), highlight the different shapes
of drawdowns. Since the longest drawdown starting in
September 1929 lasted 25 years, we limit the chart to the
first four drawdown years in order to improve readability.
2/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel
For institutional investors only / not for public viewing or distribution

Chart 1: Strong dispersion of historical S&P 500 one should differentiate between longer-stretched draw-
Price Index drawdowns with respect downs on the one hand, and very sharp / abrupt draw-
to duration and magnitude downs on the other hand. Generally speaking, the former
0% can be tackled by deploying medium- to longer-term
– 10 % trend-following CTAs, while the latter form of drawdowns
– 20 % can better be confronted with long volatility strategies.
– 30 %
Trend-following CTAs as drawdown mitigators
Drawdown

– 40 %
– 50 % When it comes to strategies that offer diversification
– 60 % during drawdowns, people often think of trend-following
– 70 % strategies. These strategies are the biggest sub-category
– 80 % of managed futures, also called CTAs (for Commodity
– 90 % Trading Advisors). Pure trend-following strategies rely
– 100 % only on prices and take a long position in a market when
0 100 200 300 400 500 600 700 800 900 000 the price trend goes up and a short position when the
Number of trading days price trend goes down. These strategies were one of the
09.1929 10.2007 03.2000 01.1973 few that performed positively during the 2008 financial
12.1968 08.1987 12.1961 12.1980 crisis as well as during other equity drawdowns. And unlike
02.1966 08.1956 plain-vanilla hedging strategies such as buying index
put options, trend-following does not come with an explicit
Source: Vontobel Asset Management, Bloomberg. ex-ante cost-burden in the form of a payable option
Past performance is no indication of current or future performance.
premium.

Table 1: Notable S&P 500 drawdowns since 1925 For our further analysis, we use the BarclayHedge
BTOP50 CTA Index as proxy for trend-following strategies.
DRAWDOWN NO. MONTHS NO. MONTHS MAX. The BTOP50 Index is an equally weighted index of the
START TO RECOVERY TO TROUGH DRAWDOWN
largest CTA programs which represent at least 50 % of
Sep 1929 301 34 – 86 % the BarclayHedge CTA universe. While there are other
Nov 2007 65 16 – 53 % trend-following indices including the SG Trend Index and
Sep 2000 81 25 – 46 % the HFRI Macro: Systematic Diversified Index, we use
Jan 1973 91 21 – 46 % the BTOP CTA Index because it has the longest history.
Dec 1968 42 19 – 33 % The chart below highlights the performance of the
Sep 1987 23 3 – 30 % BTOP50 CTA Index during all S&P 500 corrections with
Dec 1980 25 20 – 24 % a peak to trough performance of at least –5 % (since
Jan 1962 20 6 – 23 % inception of the BTOP50 in 1987). The blue bar shows the
Aug 1956 26 17 – 19 % performance of the BTOP50 CTA Index during the peak
Feb 1966 15 8 – 18 % to trough period of the S&P 500, the yellow bar shows the
Jun 1990 9 5 – 16 % performance of the BTOP50 CTA Index from peak until
Jul 1998 5 2 – 16 % recovery of the S&P 500.

Source: V
 ontobel Asset Management, Bloomberg. Chart 2: BTOP50 CTA Index performance was positive
Past performance is no indication of current or future performance.
during the major drawdowns of S&P 500,
but not necessarily during smaller corrections
One striking distinction is the length of the “under-water” 100 %
period. For example, while it took 25 years to recover 80 %
the drawdown starting in 1929 purely in nominal terms 60 %
(please note that we do not use total returns here, i.e. 40 %
dividends are not reinvested), recent drawdowns had 20 %
shorter durations. Another difference is the various paths 0%
of the individual drawdowns. In 1987, it took only slightly – 20 %
more than three months to get from peak to a 32 % trough. – 40 %
On the other hand, the drawdown starting in 1968 only – 60 %
reached its trough after roughly one and a half years. Both
11.2007

09.2000

09.1987

06.1990

07.1998

10.2018

06.2015

02.1994

01.2000

01.1990

07.1999

02.2018

08.1997

04.2000

09.1991

drawdowns needed, however, a similar time to recover

from trough to peak. Another interesting detail is that with
exception of the drawdowns in 1929 and 1987, the majority Drawdown start date
of S&P 500 drawdowns reached –20 % only after about Max. Drawdown S&P 500
five months from peak. CTA Performance to Trough
CTA Performance to Recovery
As the data above shows, each drawdown has its unique
features, which calls for a diversified as well as tailor-made Source: Vontobel Asset Management, Bloomberg, BarclayHedge.
Past performance is no indication of current or future performance.
drawdown management approach. At the very minimum,
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Performance of the BTOP50 CTA Index was positive in
the five major S&P 500 corrections since 1987, while
performance during smaller corrections (including the
one starting in October 2018) was mixed.
We pick the two worst drawdowns of the S&P 500 Index
to show the evolution of the performance of the BTOP50
CTA Index during the S&P drawdown. In the November
2007 drawdown, the BTOP50 CTA Index generated
positive performance during the initial phase of the draw-
down and managed to keep these gains during the
recovery phase of the S&P 500 Index.
Chart 3: In the November 2007 S&P 500 drawdown,
the BTOP50 CTA Index was positive during
the initial phase and protected its gains during
Based on the often noticed positive performance of trend-
following strategies during longer equity drawdowns,
but also during extended upward trends, the term “CTA
smile” has become established. We get this pattern
by plotting the monthly returns of the S&P Index on the
horizontal and the corresponding monthly returns of
the BTOP 50 CTA Index on the vertical axis of a scatter
chart and then fitting a second order polynomial. The
charts below show the “CTA smile” with data since 1987,
first with monthly, then with quarterly returns.
Chart 5: The “CTA smile” with monthly data shows
the tendency of CTAs to perform well
in the most positive or negative months
in equity markets

BTOP50 CTA, monthly return

25 %
2nd order polynomial: y = 1.06x 2 + 0.00x + 0.00
the recovery phase of the S&P 500 Index 20 %

in same period
80 % 15 %
60 % 10 %
40 % 5%
20 % 0%
0% –5 %
– 20 % –10 %
– 40 % –20 % –10 % 0% 10 % 20 % 30 %

– 60 % S&P 500, monthly return

10.2007 10.2008 10.2009 10.2010 10.2011 10.2012
S&P 500 BTOP50 CTA Source: Vontobel Asset Management, Bloomberg.
Past performance is no indication of current or future performance.

Source: Vontobel Asset Management, Bloomberg, BarclayHedge.

Past performance is no indication of current or future performance.
Chart 6: When we use quarterly returns,
the “CTA smile” becomes more pronounced
In the September 2000 drawdown, the BTOP50 CTA 25 %
BTOP50 CTA, quarterly return

2nd order polynomial: y = 1.57x 2 – 0.08x + 0.01

Index was not only able to generate positive performance 20 %
during the initial phase of the drawdown, but actually also 15 %
in same period

during the recovery phase. 10 %

5%
Chart 4: In the September 2000 drawdown, 0%
performance of the BTOP50 CTA Index –5 %
increased even during the recovery phase –10 %
of the S&P 500 Index –20 % –10 % 0% 10 % 20 % 30 %

80 % S&P 500, quarterly return

60 %
Source: Vontobel Asset Management, Bloomberg.
40 %
Past performance is no indication of current or future performance.
20 %
0%
– 20 % The smile is more pronounced, i.e. shows a higher curva-
– 40 % ture or convexity, for quarterly returns. It is worth noting
– 60 % that most other hedge fund strategies show a negative
2000 2001 2002 2003 2004 2005 2006 smile or smirk with respect to equity returns.
S&P 500 BTOP50 CTA
The “CTA smile” highlights two features of trend-followers:
Source: Vontobel Asset Management, Bloomberg, BarclayHedge. First, trend-followers increase their exposure when trends
Past performance is no indication of current or future performance.
extend, i.e. let the winners run, and cut losing positions
quickly, be it on the long or the short side. In mathematical
The reasons why trend-following performance was not finance jargon we would say that they are long gamma.
equally strong in the above examples are manifold and may Second, trend-followers need the trends to last a certain
be due to factors such as different trend opportunities in time in order to build their profits. We consider the follow-
asset classes beyond equities (fixed income, currencies ing factors important when assessing a trend-follower’s
and commodities), the initial positioning of the index funds, reaction to a drawdown: holding time, positioning at the
the composition of the index and strategy changes in onset of a drawdown, and asset allocation.
the index funds.
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The holding time measures the reaction time or speed of
a trend-follower. This varies between individuals from
40 to 120 days for the majority. This indicates that trend-
followers generally do not profit from drawdowns that
are brief. In recent years, initial signs of equity draw-
downs have often resulted in central bank actions and
rhetoric that stopped the drawdowns and generated
“whipsaw” price behavior. This environment was detri-
mental to trend-following performance; the shorter the
holding period and more reactive the strategy, the higher
the risk of being “whipsawed” by repeatedly sharp price
This contrasts with many other active strategies as well
as equities which exhibit fat left tails, i.e. negative skewness.
The chart below shows the historical evolution of the roll-
ing 36-month skewness of the BTOP50 CTA Index. After
being positive for a long time, it turned negative in February
2018, and overall we notice a downtrend in skewness.
Chart 7: The rolling 36-month skewness of the
BTOP50 CTA Index was mostly positive
in the past, but a downtrend is noticeable
1.5

Skew (absolute)
reversals. Not surprisingly, some trend-followers have 1.0
therefore increased the holding-period of their programs, 0.5
thus slowing the reaction time and reducing the risk of 0.0
being whipsawed. These trend-followers’ reduced trading – 0.5
speeds, however, come at the expense of higher market

12.2009
12.2003

12.2005

12.2007
12.1999
12.1993

12.2001
12.1989

12.1995

12.1997
12.1991

12.2011

12.2013

12.2015

12.2017
beta and reduced convexity since they take longer to
adapt to emerging trends.

The positioning at the onset of drawdowns is another
factor to consider when looking at the behavior of trend-
followers in a drawdown. If a drawdown follows just on
the back of a long-lasting, smooth uptrend, trend-followers
will have built up substantial long equity positions. In the
first phase of the equity correction, trend-followers will
therefore suffer losses on their equity allocation which
can, absent of profit-generating trends in other classes,
lead to initial losses in parallel with equities. The period
January / February 2018 exemplified such an environment
and highlighted the path-dependency of trend-followers’
positioning and correlation to equity markets.
Finally, an important part of trend-followers’ edge comes
from allocating across asset classes, i.e. including fixed
income, commodities and currencies. The number of
futures contracts invested in can range from 50 to 150
across the globe, and the individual allocations are broadly
diversified across contracts, so profitable trends may
arise from various sources. Consequently, historical trend-
following contributions during equity drawdowns came
not only from short positions in equities, but also from
other asset classes. For example, a substantial part of
the 2008 trend-following performance came from fixed
income and commodities. The allocation to the asset
classes and individual contracts is highly dependent
on the portfolio construction process of the individual
managers. As a result, the performance dispersion
of trend-followers is significant, although the strategy
seems relatively homogeneous at first glance. This favors
investing in a diversified portfolio of high-quality trend-
followers rather than a single CTA, in order to optimize
AUM ($ Billions)
Source: Vontobel Asset Management, Bloomberg, BarclayHedge.
Past performance is no indication of current or future performance.
While the trend-follower features were widely acknowl-
edged in the past, the recent period of muted trend-
follower performance has caused much discussion about
the return potential for trend-following going forward.
The main points of criticism are:
–– The strategy’s presumed simplicity makes it easy to
replicate. This has led to big inflows and an over-
crowding in the space.
–– Markets have become more efficient, hence the
behavioral inefficiencies that trend-followers rely on
to make profits have diminished.
–– The unprecedented liquidity flood and increased
market control and coordination of central banks
has interrupted emerging trends, especially on the
downside, and generated whipsaws which have
led to losses for trend-followers.
With regards to the first point, a September 2018 analysis
by AQR1 concluded that while trend-following assets
peaked in 2008 at USD 211 billion, they have since
decreased and were running at USD 124 billion by mid-
2018.
Chart 8: Estimated Managed Futures AUM
January 2004 – June 2018
230
$211 B
210
190

170
overall risk-reward. 150
130
Trend-following: Recent pro and con debates 110 $124 B
Returning to the CTA smile, it also shows evidence of 90
positive skewness, a feature of trend-followers which is 70
highly sought-after for protecting against equity draw- 50
downs and complementing negatively skewed strategies. 2004 2006 2008 2010 2012 2014 2016 2018
This means that compared to a normal distribution,
Source: AQR
the return distribution of trend-followers has more pro-
nounced positive returns than negative ones, mainly
an effect of the “let winners run, cut losers quickly” rule. 1
AQR (2018), “Trend Following in Focus”
5/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019
For institutional investors only / not for public viewing or distribution
At the same time, AQR points out that futures markets
have increased in size over the same period.
Chart 9: Futures Markets Open Interest
January 2004 – June 2018
24
Rolling 3-Month Median Open Interest
20
(Number of contracts, in millions)
16
12
8 following managers face a dilemma: Available futures
4 should not over-fit the optimization parameters, in order
0 underperform with new data going forward. A tolerance
2004 2006 2008 2010 2012 2014 2016
Commodities Equities
Fixed Income Interest Rates
Source:
(For bothAQR
Chart 8 and Chart 9) eVestment Managed Futures Category, AQR, Bloomberg.
As of June 30, 2018. For Chart 9: The above open interest, per asset class, is based on
a hypothetical basket of aggregated open interest for individual futures markets across
equities, fixed income, interest rates, and commodities. Open interest is computed
using the rolling 3-month median on the aggregated open interest for each asset class.
Hypothetical data has inherent limitations some of which are disclosed herein. For
Illustrative purposes only and not representative of any strategy that AQR currently
manages.
Source: AQR
AQR thus concludes that the slice of trend-followers in
the futures markets has decreased and there is there­-
fore little evidence that the trend-following space is over-
crowded.
With respect to diminishing profit opportunities for trend-
followers, some studies conclude that risk-adjusted
returns (Sharpe ratios) for trend-following strategies have
decreased in recent years. This could be an effect of
higher market efficiency. Some managers have therefore
expanded into so-called exotic markets (interest rate
swaps, credit indices, power markets, exotic commodities,
etc.), where Sharpe ratios are still higher but liquidity is
less ample. While the applied algorithms are similar, liquidity
management and trade execution quality are crucial, and
the required operational efforts are significantly higher.
Considering the convexity of trend-following strategies,
the sometimes heard statement that trend-following
has stopped working should be taken with a grain of salt.
The increased interventions by central banks in the past
few years have created a new environment with lower
market volatility and fewer trends, but it seems danger-
ous to extrapolate the recent past into the future.
Vontobel
Trend-followers tend to generate substantial profits unex-
pectedly in a short time after long drought periods, for
which the first quarter of 2019 may serve as an example.
Timing is therefore nearly impossible and there is a risk
of leaving the strategy just before another performance
boost, which happened to quite a few investors losing
faith in trend-following just prior to the 2014 performance
spike. Managers like AQR 2 or CFM3 found that trend-
following has been working for over one hundred years,
hence the recent period may just be an interim period.
Not all trend-following CTAs are created equal
It should, however, be taken into account that trend-
data enable extensive back-tests. Ideally, managers
to avoid that a strategy with a brilliant back-test does not
2018 for some underperforming phases where strategies do
not work is therefore a logical consequence, and all long-
standing trend-following managers have incurred some
longer and pronounced drawdowns – which could be
called a “pain premium” paid for the positive convexity
of the strategy. With respect to the more recent past,
the question therefore arises whether the results are still
within the statistical norm or whether an adaptation
of the strategy may be justified. Managers have opined
divergently: While some trend-followers change as little
as necessary, others have added some non-trend compo-
nents or long biases which may increase the Sharpe ratio
but come at the cost of reduced skewness and convexity.
Winton, a renowned manager, has drastically reduced
the allocation to trend-following in its flagship product.
The risk, however, is that the more a manager adapts his
strategy to a less-trendy environment, the less he may
profit in an eventual large drawdown.
So where does this lead in the context of drawdown
management? The paragraphs above have outlined that
each drawdown has its own individual evolution. While
trend-following is a strategy that may provide diversifica-
tion in drawdowns, the diversification benefit depends
on the shape, duration and extent of the drawdown
itself and on the characteristics of the respective trend-
followers such as trading speed, purity of the trend-
following approach, portfolio management and asset
allocation as well as positioning at the start of the draw-
down. To cope with a broad set of environments, a blend
of trend-following managers providing diversification
across these parameters is necessary, but not sufficient.
Due to their systematic “backward-looking” approach,
trend-following strategies will struggle in certain types
of drawdowns where a more forward-looking and
discretionary approach may excel – as is the case for
global macro as well as several long volatility strategies.
2
 urst B., Ooi Y. H., Pedersen L. H. (2017),
H
“A Century of Evidence on Trend-Following Investing”
3
 apital Fund Management (2015),
C
“Trend Following: A Persistent Market Anomaly“
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Global macro strategies: A good complement to CTAs for
building a holistic drawdown management portfolio
Global macro strategies tend to share a few characteristics
with CTAs which are crucial for drawdown management
purposes: Positive convexity/skew as well as the ability to
go net short entire asset classes in size.
On the other hand, global macro strategies differ from
(trend-following) CTAs in important ways, making them a
valuable complement for drawdown management pur-
poses. The main differences to trend-following CTAs are
global macro’s discretionary (non-systematic) use of fun-
damental information to trade a generally broader suite of
instruments (often options) in a forward-looking manner.
There is no “hard and fast” definition of global macro
strategies. The main common denominator of global
macro managers is their forward-looking focus on broader
economic, regional and asset class shifts. Other than
that, the global macro scene is extremely diverse, as illus-
trated in the table below. This also explains why global
macro indices are of rather limited use when assessing
global macro’s suitability as drawdown management
strategy. Rather than looking at global macro from an
extremely heterogeneous (and thus diluted) index level,
it seems more fruitful to look at individual styles (and
managers): Some of them prove rather valuable as draw-
down mitigators, while others might even turn out counter-
productive.

Table 2: Global macro strategies vary widely in approach and are not always preferable for drawdown management

DESCRIPTION PREFERENCE FOR DRAWDOWN MANAGEMENT PURPOSES

Directionality Ranging from completely directional to overwhelmingly Prefer trading markets more directionally, with real macro
relative value (incl. some micro RV) relevance /sensitivity and relatively lower gross leverage

Linear vs. Ranging from completely linear expressions (e.g. futures, Mix of linear and options-based implementations (crucially
Non-linear forwards) to completely options-based implementations only long options), with a bias to options- and options-like
(i.e. long gamma) trading styles

Amount of Ranging from strongly positive net vega to moderately Prefer positive vega portfolios
net vega negative vega portfolios

Geography Ranging from truly global approaches to regional focuses Build portfolio of regionally diversified approaches,
(e.g. emerging or developed markets) with sufficient emphasis on major markets

Asset Class(es) Ranging from truly multi-asset class (incl. equities, Mix across asset classes, conditional on good liquidity
commodities, credit) to more rates- or FX-focused also during stress scenarios
approaches. Ranging from purely intra-asset class to
overwhelmingly cross-asset class expressions

Trading speed Ranging from very strategic 1-2 year trading horizons Mix of time horizons, with a tilt to relatively faster trading
to very tactical, even intra-day approaches speeds – even more so, when medium to long-term
trend-following CTAs are already deployed in the portfolio

Sources of Ranging from purely fundamental data-driven to over- Mix between price and non-price input data
information whelmingly technical approaches.

Originality of Ranging from mainstream/equilibrium views to more Tilt to managers with relatively less mainstream, more
views “long shot” (i.e. less probable, less priced-in) variant views (given convincing arguments and sufficient
investment ideas risk controls)

Risk bias Ranging from significantly long-biased (balanced portfolio) Avoid long-biased managers, in all their explicit and implicit
approaches to moderately short-biased styles forms. We prefer a mix between unbiased and (tactically)
short-biased managers/strategies

Degree of Ranging from one theme / trade to dozens of themes / trades Mix of diversification degrees. This is conditional on the
diversification more concentrated managers / strategies being sufficiently
robust /convex to withstand adverse market moves

Momentum vs. Ranging from mainly momentum / break-out driven to Prefer momentum and momentum-like strategies (i.e.
mean-reversion largely mean-reversion / value-oriented approaches positive gamma), for which disciplined risk management
is a key feature

Degree of Ranging from overwhelmingly intuitive (synergistic) Mix of information processing approaches. Avoiding overly
intuition approaches to analytically refined, more quantitative optimized/fragile approaches, which might be overly
approaches reliant on the more recent past. Preference for “skeptics”
as well as risk-conscious and nimble traders

Number of Ranging from single-risk taker model to dozens Tend to avoid overly diversified multi-PM strategies, as their
risk-takers of risk-takers portfolios often tend to be somewhat diluted, for the sake
of higher performance-stability
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For institutional investors only / not for public viewing or distribution
Global macro style selection: Separating drawdown
management “wheat from chaff”
First of all, one has to avoid falling into an overly narrow,
myopic and backward-looking bias often associated with
crisis-protection strategies. This tendency of “fighting
the last war” led many investors to flock to conventional
tail-protection strategies (e.g. buying short-dated equity
volatility) right on the back of the Great Financial Crisis
2008. Buying the kind of “protection” which worked best
during the last crisis often turned out to be the most
expensive protection. Just as important, both market
participants’ as well as regulators’ various reactions to a
past crisis often render a crisis in the same “spot” (e.g.
market or country) less likely. There are some similarities
to the situation after a plane crash occurred: Risk aware-
ness and mitigation measures often lead to the post-
crash risks actually decreasing rather than increasing –
while consumers’ (behavioral) reaction goes the other way.
A key aspect when investing in global macro strategies
for drawdown management purposes is to look at each
manager and style individually, given their high heteroge-
neity. For example, the January 15, 2015 Swiss Franc
de-peg from the Euro saw some macro managers score
big, while others suffered significant losses. If the losers
and winners among macro managers during this particu-
lar episode had been randomly distributed, there would
be no point in trying to select specific managers. How-
ever, the outcome for specific macro managers (and their
related style of macro trading) was anything but random:
There was a clear tendency of managers with long con-
vexity profiles to score big, in some instances in the order
of +30 %. These managers’ positive convexity was cre-
ated mostly by being long options and positioned for a
divergence of the Euro-Swiss Franc trading range, as well
as by being skeptical about the Swiss National Bank’s
stamina (and willingness) to stay their course and “walk
their talk.”
Opportunities for global macro during drawdowns
More recently, the following short-biased macro and
long-volatility themes have been observed repeatedly:
–– Short corporate credit (incl. HY) and EM credit. Also
includes short-selling of credit exchange-traded
funds (e.g. high yield, bank loans), which might be
vulnerable to a liquidity mismatch in the face of
potentially large investor outflows, and thus offer
asymmetric short opportunities.
–– Long (medium-term) volatility across equity indices,
rates and currencies. More recently also in certain
precious metals (e.g. gold).
–– Risk-off spread-wideners (e.g. basis wideners and
asset swaps) which tend to profit during liquidity
squeezes and flight-to-quality episodes.
–– Targeting currency devaluations, i.e. selectively short-
ing emerging market currencies (e.g. in Eastern
Europe and Middle East) vulnerable to a devaluation
against the USD or EUR.
Positive convexity comes with varying price tags
In principle, positive convexity can be created by simply
buying put and call options on the desired underlying
Vontobel
market, so-called straddle and strangle option strategies.
Although this simple strategy literally guarantees positive
convexity, it unfortunately comes with a hefty price tag:
Substantial premium time decay on the options acquired.
Hence, this approach to creating convexity only tends to
be sensible if the market prices for volatility (implied vola-
tility) are very cheap and / or the timing of an anticipated
larger price move is spot-on, thus losing less time value.
Trading strategies, on the other hand, tend to spend a
relatively small amount of capital on directly buying
options. Depending on their specific trading styles, they
deploy various means to generate positive convexity
in less expensive ways:
Disciplined risk management
Most global macro managers use pre-defined stop-
losses on both the portfolio as well as on a position / 
theme level, and most CTAs have systematically built-in
sliding stop-losses as well. This key feature of most trading
strategies of adding to winners and cutting losers is a
crucial source of convexity, coming at the cost of being
“whipsawed” every once in a while, when market prices
oscillating in a range lead to the trading strategy getting
stopped out repeatedly at the (in hindsight) wrong spots.
Selectively investing in fundamentally
asymmetric market constellations
An extreme example of this was going long credit-default
swaps protection around 2006 / 07, due to their being
very cheap, i.e. only having priced a minimal likelihood of
a credit meltdown. Similarly, shorting the Euro against
the Swiss franc ahead of the January 2015 peg break
also offered a strongly asymmetric opportunity; as the
exchange rate came ever closer to the 1.20 floor, the
Swiss National Bank got nervous, and the positioning of
investors was crowded in the belief of the status quo
holding.
Balanced portfolio construction
The ability to go both long and short different markets
and the general absence of either a long or short bias
enables a trading strategy to run during various market
regimes. For instance, trading strategies tend to be about
the only major investment strategies with the ability to
go (materially) short during market downturns. The ability
to survive can be crucial in the event of major market
regime shifts, enabling the trading strategy to capitalize
on the dislocation rather than falling prey to it.
The above-listed techniques for generating convexity are
essential elements not only for weathering, but usually
capitalizing in a changing, higher-volatility market envi-
ronment. The goal of investing in high-quality trading
strategies is twofold: First, minimize the cost of positive
convexity by finding clever ways to generate it. Second,
investing in a diversified, complementary array of trading
strategies buffers a portfolio well for various forms of
“higher-volatility” or market “downturn” environment.
In brief: Not all volatilities are created equal, nor are all
market downturns created equal.
8/8 Asset Management / Multi Asset Boutique /Alternatives & Multi Manager Solutions / May 2019 Vontobel
For institutional investors only / not for public viewing or distribution

Conclusion However, a differentiated and selective approach to

Drawdowns take many forms, varying by the market(s)
affected, length, severity as well as price path. This
necessitates a clear understanding of which drawdowns
to prioritize when designing drawdown management
strategies. Given the defined drawdown scenarios to pro-
tect against, the most suitable drawdown management
strategies (such as different CTAs and global macro
programs) can then be combined to maximize protection
effectiveness while keeping the costs associated with
achieving positive convexity low.
More specifically, trend-following CTAs have a long history
of positive contributions during equity market drawdowns.
Their positive convexity (“smile” on the return scatter plot)
is rather pronounced. This valuable positive convexity
is also exhibited by many global macro strategies (unlike
most other hedge fund strategies), also rendering them
an appealing drawdown management strategy. CTAs and
global macro complement each other well, as the latter
tends to trade more options and use fundamental infor-
mation in a forward-looking manner.
selecting CTAs and global macro strategies is warranted
when constructing drawdown management portfolios:
Global macro strategies are rather heterogeneous and
CTA programs also evolved in recent years – marking
some of them suitable and others unsuitable for draw-
down mitigation purposes.
Not unlike insurance, one could do without drawdown
management strategies like CTAs and global macro and
ostensibly “save” money as long as no “accident” occurs.
Only time will tell whether this “goldilocks” regime will
continue or make way to a more turbulent environment.
To borrow again from surfing, catching and riding up­-
coming big waves means having the strategies to
dynamically navigate different scenarios. Drawdown
management strategies repeatedly proved their value
in times of stress – this time is (usually) not different.

Ilario Scasascia, CAIA Daniel Germann Florian Albrecht, CFA

Head of Alternatives & Senior Portfolio Manager Senior Portfolio Manager
Multi Manager Solutions Director Director
Executive Director

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