“A ‘receding sea’ is not a lucky offer of an extra piece of free beach, but the warning sign of an upcoming tsunami.” ― Jos Berkemeijer

Most of the metrics we’ve implemented at MFO address down-side risk. Our principal MFO Rating is based, not on Sharpe, but on Martin, which uses the so-called Ulcer Index to normalize any excess return. Ulcer Index …

(Peter Martin was recently mentioned in Brain Livingston’s article: “Widely followed risk-return measure for stock portfolios is debunked after 55 years.” It is not Martin Ratio.)

Martin is a risk adjusted return measure that answers the question: how much pain (drawdown) is involved with the return I receive? Ex post (after the fact), of course.

The introduction of our Bear Market Rating in the April 2015 commentary, entitled “Identifying Bear Market Resistant Funds During Good Times,” is an attempt to forecast (ex ante) how funds will behave when the market falls protractedly.

The Bear Rating represents a decile ranking (1 to 10 where 1 is most bear market resistant) of funds in a given category, based on bear market deviation (BMDEV). The deviation indicates typical percentage decline based only on a fund’s performance during bear market months, which Morningstar defines as a 3% drop for equity funds and a 1% drop for bond funds.

In addition to focusing on metrics that address down-side risk, our fund screeners have evolved in response to inputs from subscribers, like Brad Ferguson (Introducing Ferguson Metrics) and James Pursley of Gaia Capital Management (Introducing MFO Premium’s Fund Compare Tool).

Recently, Michael Sullivan of Chesney Sullivan Wealth Advisors (a Raymond James associate) based in Naples, FL queried us about the Bear Market Rating for a particular fund, which seemed inconsistent with other ratings, like those for drawdown itself (MAXDD) and Martin. He was examining a bond fund using an evaluation period of six years.

The US stock market has begun experiencing volatility this past year or so, reversing rather lengthy period of Historically Low Volatility. The S&P 500 retracted more than 3% three times this past year, on a month ending basis through August … -6.3% in May, -9.0% this past December, and -6.8% in October 2018. Fortunately for equity investors, the market recovered in subsequent months.

It is precisely such short-term retractions (aka “Bear Market Months”) that the Bear Market Rating methodology relies upon. But in the year leading up to last October, there was just a single such month … in three years before that, just two occurrences!

And the bond market? Since the “taper tantrum” in May of 2013, the US Bond (Bloomberg Barclays U.S. Aggregate Bond Total Return) Index has retracted more than 1% just three times … -1.2% in January of 2018, -2.4% in November 2016, and -1.1% in June 2015. That’s it! So, there has simply not been a lot to data to determine the Bear Market Rating on bond funds over the period Michael was evaluating.

To help address this issue, beginning with the month-ending September data, which Lipper (now Refinitiv) should drop this weekend, the MFO Premium site will incorporate a new Down Market Rating. Like its Bear Market Rating companion, it will attempt to gauge the pain investors may feel during a more protracted downturn by assessing the proceeding down only months, or pure downside risk. No threshold will be imposed.

While there have only been three bear market months for bond funds and eight for stock funds the past six years, there have been 27 months when the US Bond Index went negative and 18 such occurrences for the S&P 500, which should provide a more robust assessment of down-side risk.

Below please find a table of Down Market Rating for the all equity funds (except Trading) in the Lipper Global Data Feed, dating back to October 2002, the beginning of the previous bull market. The rating is assessed during the up cycle period preceding the 2008 bear market. Then, it shows the average maximum drawdown (MAXDD) for those same funds in the bear market. The result appears quite satisfactory.

A few other notes …

There were 16 down market months for the S&P 500 during the up cycle between October 2002 and October 2007. (There were 21 for the US Bond Index.) As always with our database, there is no accounting for survivorship bias.

The ratings above are also relative to all equity funds not category peers. We will start using the same approach for the Bear Market Rating. Ratings for these two metrics, like our overall MFO Risk metric, will be relative to the broader market not just category, which can give a false sense of security. While funds may appear tame in category (e.g., energy funds), they can still be quite volatile overall.

The average MAXDD for the equity funds above when both Bear and Down Market Ratings are 1 (20 funds) is just -32.3%.

We will also add number of bear and down market months of the MultiSearch results display, in addition to the ratings and attendant deviations. Finally, we will add a table to the MultiSearch Analytics tool showing the monthly fund total returns during all bear and down months since launch.

Sincere thanks to Michael Sullivan for reaching out!

Hoping this new metric and refined approach helps.