Analysis of the Drawdown

Originally published in the Brandywine Asset Management Monthly Report.

Brandywine employs a wide variety of trading strategies, each systematically applied, to trade across more than 100 global financial and commodity markets. The intent of this broad strategy and market diversification is to enable more consistent performance across a range of market conditions. Brandywine’s Symphony Program was able to accomplish this over our first three years of trading, earning consistent returns while managed futures traders suffered their longest drawdown on record. And when trend following futures traders did have positive periods, more often than not, so did Brandywine. We also posted profits during the most difficult stock market environments, such as the third quarter of 2011. So what made the past four months different?

A number of Brandywine’s trading strategies exploit extremes in market sentiment, pricing relationships between various markets and fundamental production data to enter into positions that are often independent of market trends. In the event trends develop that are contrary to those positions, Brandywine also employs momentum strategies designed not only to independently produce profits, but also to “hedge” that fundamental and sentiment exposure by offsetting a portion of those positions.

As most of our investors and readers are well aware, the last half of 2014 contained some significant market trends, such as the collapse in the oil market and the relentless rise in the value of the dollar. These were ideal conditions for trend followers to profit, and at first Brandywine also benefitted along with them. During August 2014, a month when trend followers performed quite well, Brandywine’s Symphony Program posted its second strongest month on record. But one person’s sunrise can often be another person’s hangover.

Towards the end of August, those same market trends began to signal opportunities – based on logical return drivers and decades of historical testing – and trigger additional counter-trend positions in Brandywine’s sentiment, fundamental & arbitrage-based strategies. As trends continued to move against those positions, our momentum hedges did help to balance the portfolio and offset a portion of those losses. The result was that the cumulative loss over the last three months of the year was only slightly greater than the single month loss in September.

However, due to the number of strategies indicating those counter-trend positions and the allocations assigned to them by our portfolio allocation model, the aggregate position sizes indicated by all strategies remained counter to the prevailing trend over that period, which, by definition, created the losses.

Going Forward
Brandywine believes strongly in the value of true portfolio diversification and the benefit of maintaining balance – over time – across the strategies and markets in our portfolio. This belief is at the core of our portfolio allocation model and is designed to provide our investors with the best possible long-term risk-adjusted returns. While we continue to believe that it is the long-term that matters most, we understand the benefit in reducing short-term “pain” as well.

Fortunately, there are ways for Brandywine to reduce the probability that future drawdowns will match or exceed the current drawdown, while still preserving our long-term performance. That is because, by design, Brandywine’s research philosophy requires the regular evaluation of the validity of the return drivers underlying our current strategies and Brandywine’s portfolio allocation model easily accommodates, and our belief in continuing improvement requires, the addition of new trading strategies into the portfolio. This is a process we’ve discussed numerous times in these reports over the past few years.

So addressing the source of the current drawdown doesn’t require an overhaul of our trading model or research process, but a continuation of the process already in place. We have been students of the markets now for more than 35 years and have developed a library of potential trading strategies based on our trading experience. We are especially focused now on an evaluation of the existing strategies that contributed to the drawdown, as well as the completion of the development of additional strategies designed to thrive on aggressively-trending markets.

There is of course no way to protect against losses under all conditions. Every investment program has market environments where it is more likely to lose than to gain. And while Brandywine’s Symphony Program has generally performed well across a variety of market conditions, the drawdown of the past four months has served to remind us of the need for continuous improvement. As always, we are committed to this process.

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