Large Drawdowns Research Articles

Investment Skill and Consistent Long-Term Alpha

How should an active investor calibrate their investment decisions, when the goal is to reach an outperformance target over the long term, without succumbing to large drawdowns in the interim? Closed-form expressions for the probability of consistent long-term alpha are derived and show that maximizing this probability requires a thoughtful calibration of skill, volatility, decision frequency, and costs. The article derives the minimum skill level for which the probability of consistent long-term alpha trends to its maximum for long investment horizons. This minimum skill level is not typically large, at only marginally above a fair coin toss. Unfortunately, the maximum probability of consistent long-term alpha is also not very large, even when skill is high and the investment horizon is long. The reason is that, although the probability of reaching the long-term goal rises with the time horizon for sufficiently high skill, so does the probability of experiencing the intertemporal loss that can force a stop-out in the interim.

Momentum Crashes and the 52-Week High

Momentum strategies suffer from occasional large drawdowns referred to as momentum crashes when the market rebounds. We find that a surge of investor speculation toward stocks far from their 52-week highs can partially explain the momentum crashes. If a momentum strategy is revised to be neutral on a 52-week high effect, momentum crashes are significantly attenuated and the revised strategy does not exhibit procyclical returns. Furthermore, the revised strategy generates a higher Sharpe ratio in different sub-periods and international stock markets.

Harnessing the Power of Exchange-Traded Products for Commodity Exposure

Exchange-traded products have proven to be an efficient and effective means for investors to gain access to asset classes such as commodities. After several years of a prolonged drawdown, commodities are beginning to regain favor with investors; however, excessive volatility and the historic propensity for large drawdowns remain an impediment for the asset class. Active managers have long successfully used time-tested principles, such as momentum, to successfully regulate exposure to commodities. In this article, the author puts forth a straightforward methodology using time-series momentum applied to commodity exchange-traded products to produce a dynamic portfolio that can provide exposure to the asset class while mitigating risk.

Application of Time Series Analysis to Estimate Drawdown From Multiple Well Fields

In 2018–2020, meteorological droughts over Northwestern Europe caused severe declines in groundwater heads with significant damage to groundwater-dependent ecosystems and agriculture. The response of the groundwater system to different hydrological stresses is valuable information for decision-makers. In this paper, a reproducible, data-driven approach using open-source software is proposed to quantify the effects of different hydrological stresses on heads. A scripted workflow was developed using the open-source Pastas software for time series modeling of heads. For each head time series, the best model structure and relevant hydrological stresses (rainfall, evaporation, river stages, and pumping at one or more well fields) were selected iteratively. A new method was applied to model multiple well fields with a single response function, where the response was scaled by the distances between the pumping and observation wells. Selection of the best model structure was performed through reliability checking based on four criteria. The time series model of each observation well represents an independent estimate of the contribution of different hydrological stresses to the head and is based exclusively on observed data. The approach was applied to estimate the drawdown caused by nearby well fields to 250 observed head time series measured at 122 locations in the eastern part of the Netherlands, a country where summer droughts can cause problems, even though the country is better known for problems with too much water. Reliable models were obtained for 126 head time series of which 78 contain one or more well fields as a contributing stress. The spatial variation of the modeled responses to pumping at the well fields show the expected decline with distance from the well field, even though all responses were modeled independently. An example application at one well field showed how the head response to pumping varies per aquifer. Time series analysis was used to determine the feasibility of reducing pumping rates to mitigate large drawdowns during droughts, which depends on the magnitude and response time of the groundwater system to changes in pumping. This is salient information for decision-makers. This article is part of the special issue “Rapid, Reproducible, and Robust Environmental Modeling for Decision Support: Worked Examples and Open-Source Software Tools”.

An Analytical Heat Transfer Model in Oil Reservoir during Long-Term Production

Contrary to the assumption of previous researchers, the radial temperature in the petroleum reservoir during production is non-isothermal because several heat transfer mechanisms change the radial temperature in reservoirs. As there have been few studies, especially after long-term production, this work derives steady-state analytic solutions considering the long-term production. It also presents sensitivity analysis with the various production conditions to investigate heat transfer between the producing fluids and surrounding formations during fluids flowing (hereafter, system heat transfer) in a steady-state. For oil production, the system heat transfer induces a cooling effect on the radial temperature in the reservoir, reducing the temperature rise due to the Joule–Thomson (J–T) heating. This cooling effect increases with the larger Peclet number, however, the relative contribution of the cooling effect to the radial temperature change diminishes. The equations explain that the cooling effect is proportional to the temperature increase due to J–T heating. With a larger permeability, a more convective-dominant phase causes more heat transfer actively. Although the cooling effect itself is amplified with the larger permeability, its relative contribution to the temperature change decreases. From the analysis, the cooling effect of system heat transfer is significant in the low-permeability reservoirs with large drawdown. The system heat transfer is confirmed to be an essential factor in measuring the accurate productivity index of unconventional reservoirs.

A saturated–unsaturated coupling model for groundwater flowing into seepage wells: a modeling study for groundwater development in river basins

As a major and popular groundwater extraction structure, seepage wells are often used to transfer river water into aquifers for harvesting water resources. It can help ameliorate the imbalance between supply and demand, in particular, in areas of water scarcity. Large drawdowns due to pumping may cause the river to disconnect from the groundwater and form an unsaturated zone, which seriously affects the efficiency of seepage wells. However, most of the current models of extraction structures of non-tube wells account for only saturated flow and do not consider unsaturated conditions. To address this limitation, a saturated–unsaturated coupling model was developed using the exchange flow rate between the well pipe and the aquifer as the coupling point. Moreover, the model was evaluated with physical simulation test data. The statistical results indicated that the model could estimate the drawdown and pumping rate well with root-mean-square deviations of 0.0114 m and 0.0079 L s−1, respectively, for a river with strong leakage capacity; and 0.0129 m and 0.0099 L s−1, respectively, for a river with weak leakage capacity. The critical drawdown, where the river disconnects from the aquifer, as well as variations of the unsaturated zone, was also discussed. The present study provides important information for the design of seepage wells with reasonable drawdown, while being able to predict the potential water yield, and at the same time help protect the groundwater environment.

Crowded Trades and Tail Risk

Abstract Hedge fund positions are an important component of crowded trades. These vehicles are particularly active, take highly concentrated positions, and utilize leverage and short sales. Using a database of hedge fund holdings, we measure the degree of security-level crowdedness. The difference between the average returns on portfolios sorted by high versus low crowdedness portfolios is sizable, and the variation in the realized portfolio returns is distinct from other traditional risk factors. Further, hedge fund exposures to crowdedness are often significant, and they help to explain downside “tail risk,” as funds with higher exposures experience relatively larger drawdowns during periods of industry distress. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Disasters, Large Drawdowns, and Long-term Asset Management

Long-term investors are often reluctant to invest in assets or strategies that can suffer from large drawdowns. A major challenge for such investors is to gain access to predictions of large drawdowns in order to precisely design strategies minimizing these drawdowns. In this paper, we describe a multivariate Markov-switching model framework that allows us to predict large drawdowns. We provide evidence that three regimes are necessary to capture the negative trends in expected returns that generate large drawdowns, and we correctly predict conditional drawdowns. In addition, investment strategies based on these models outperform model-free strategies based on the empirical distribution of drawdowns. These results hold within and out of the sample.

Identification of non-Darcian flow effect in double-porosity fractured aquifer based on multi-well pumping test

Well testing in double-porosity fractured aquifers or oil and gas reservoirs is one of the long-lasting research problems in subsurface hydrology and petroleum engineering, where the double-porosity implies that the media of concern can be approximated as a two interrelated continuums (fracture network and rock matrix) with two distinctively different porosities. However, most of those studies in double-porosity fractured aquifers only concern Darcian flow in the fractured continuum. In this study, we will expand such studies from Darcian flow regime to non-Darcian flow regime, which is most likely to be the case for the field well testing site reported in this investigation. New solutions based on power law and a linearization approximation are obtained for hydraulic heads in Laplace domain and subsequently inverted to give spatiotemporal distributions in real-time domain. The non-Darcian flow model in single porosity media is obtained by setting the leakage coefficient (C) to 0 or the storage coefficient of the matrix (Sm) to 0, where C is the rate of fluid transfer between the fracture and rock matrix. Parameter analysis is conducted using dimensionless formats. A larger dimensionless quasi conductivity coefficient KqD, a larger drawdown in the early stage, and a smaller drawdown in the late stage. The dimensionless parameters CD and ϕ influence the drawdown in transitional state, and the values get larger, the drawdown in transitional state drop smaller. A pumping test conducted in Huangtun, Anhui province of China has been applied to test the non-Darcian flow effect in a double-porosity aquifer, in which a particle swarm optimization (PSO) algorithm will be applied here to seek the optimal hydraulic parameters. As the result shows, the observed drawdown data fit well with the new model in the pumping stage. The predicted recovery drawdown curve with the calculated parameters of the new model also performs well with the field drawdown data, which supports the applicability of the new model to interpret the field data.

Semi-analytical solutions for transient flow to a partially penetrated well with variable discharge in a general three-layer aquifer system

A general semi-analytical model for transient flow in a three-layered aquifer system with a partial penetration well having a variable discharge of pumping is developed with the consideration of the interface flow on the adjacent layers. This general three-layer system includes the conventional aquitard-aquifer-aquitard system as a subset and does not require that the permeability contrasts of different layers must be greater than a few orders of magnitude and does not ignore any flow components (either vertical or horizontal) in any layer. The pumping well of infinitesimal radius is screened at any portion of the middle layer. Three widely used types of top and bottom boundary conditions are assigned prescribed head (Case 1), zero flux (Case 2), or prescribed head at top and zero flux at bottom (Case 3). Laplace domain solutions for dimensionless drawdown are obtained using Hankel transformation, and associated time-domain solutions are evaluated numerically. The newly obtained solutions include some available solutions for two- or single-layer aquifer systems as subsets. The drawdowns for individual layers caused by a well with an exponentially decreased discharge are explored as an example of illustration. The results indicate that the pumped layer drawdown close to the partially penetrated well is mainly influenced by the variable pumping rate. The late-time drawdown for all layers is remarkably affected by the chosen types of top and bottom boundary conditions, and the drawdown for Case 3 is greater than that for Case 1 and smaller than that for Case 2. Additionally, the effect of the pumped layer anisotropy on drawdowns in the three-layer system is significant, and the anisotropy of the unpumped layers significantly affects the drawdown in the whole aquifer system without large contrast of hydraulic conductivity between the unpumped layers and the pumped layer. The drawdowns in all three layers are greatly affected by the location and length of well screen, and a larger drawdown can be seen at the position that is closer to the middle point of the screen of the partially penetrating pumping well.

Patience with Active Performance Cyclicality: It’s Harder Than You Think

Patience in investing is the capacity to endure periods of underperformance in hopes of achieving an investment objective. For many investors, outperforming the broad market through traditional active management or factor-based investing is a key goal—and one that requires significant patience to achieve. In this article, the authors quantify the wide range of frequencies, durations, and magnitudes of underperformance that both equity factor tilts and outperforming traditional active managers experience. Their findings show that almost all outperforming traditional active equity managers and equity factors have frequent periods of underperformance relative to the equity market, some of which are long in duration and large in magnitude. Investors can expect to experience a drawdown of between 40% and 60% for all one-year evaluation periods. Additionally, an outperforming manager can expect to experience a continuous drawdown lasting 2 years or more every 10 years and a drawdown of at least 20% over time. <b>TOPICS:</b>Factor-based models, security analysis and valuation, performance measurement <b>Key Findings</b> ▪ The authors found that close to 100% of outperforming funds have experienced a drawdown relative to their style and median peer benchmarks over one-, three-, and five-year evaluation periods. ▪ Eight out of 10 outperforming funds had at least one five-year period when they were in the bottom quartile relative to their peers. This is especially important to understand given an industry survey that found that 89% of senior executives with asset allocation responsibilities would not tolerate underperformance for more than two years before seeking a replacement (State Street Global Advisors 2016). ▪ More than half of outperforming active equity funds have underperformed their style and median peer benchmark by at least 20%—and three-quarters of funds that recovered from their largest drawdown took more than three years to do so.

Predictability of stock market indexes following large drawdowns and drawups

The efficient market hypothesis is one of the most popular subjects in the empirical finance literature. Previous studies of the stock markets, which are mostly based on fixed-time price variations, have inconclusive findings: evidence of short-term predictability varies according to different samples and methodologies. We propose a novel approach and use drawdowns and drawups as triggers, to investigate the existence of short-term abnormal returns in the stock markets. As these measures are not computed within a fixed time horizon, they are flexible enough to capture subordinate, time-dependent processes that could drive market under- or overreaction. Most estimates in our results support the efficient market hypothesis. The underreaction hypothesis receives stronger support than does overreaction, with higher prevalence of return continuations than reversals. Evidence for the uncertain information hypothesis is present in some markets, mainly after lower-magnitude events.

Long-Term Investing in Triple Leveraged Exchange Traded Funds

The phrase long-term investing in triple leveraged ETFs is somewhat of an anathema for investment academicians. As a result of daily rebalancing and so-called beta slippage or “the constant leverage trap” it is highly likely over the long term to significantly deviate from the targeted leverage and, in so doing, generate wipeout losses. In fact, the data show that many 3X leveraged ETFs have performed poorly over the long term in the period of their existence. However, there are some significant exceptions. The 3X leveraged Nasdaq ETF, TQQQ, for example has delivered a total return exceeding 10,000% (CAGR of 54.4%) over the 10+ years of its existence, more than 13 times the total return of its underlying ETF (QQQ). Similar, but less impressive numbers have been achieved with triple leveraged ETFs that target the S&P 500 and the Dow Industrials. These results, however, are accompanied by excessive volatility and very large maximum end-of-month (EOM) draw downs, in excess of 49% for TQQQ, and with maximum daily drawdown of almost 70%. Many retail investors would be unwilling to sustain such (paper) losses. Here we propose a strategy to mitigate these large draw downs while still retaining much of the upside performance of triple leveraging. We show that by simply establishing a portfolio consisting of an equal dollar amount of TQQQ and TMF (the triple leveraged ETF linked to the 20+ year treasury bond), and performing bimonthly rebalancing, a total return, after transaction costs, in excess of 5,800% (CAGR of 44.9%) would have been achieved over the 10+ years of TQQQ existence, with the maximum EOM draw down less than 25%.

Groundwater flow modelling for an assessment of abstraction and climate change impacts on groundwater resources—an example from the Wadi Araba Basin (Jordan)

The Wadi Araba Basin is a desert area in which finding water represents a real challenge. One potential source for the abstraction of groundwater is a sandstone aquifer which is partly covered by alluvial sediments distributed along the Wadi Araba Valley. The study analyses the impacts of abstraction and climate changes on groundwater quantity. It also aims to define a safe yield for the groundwater resources and to locate new wellfields in hydrogeological areas that will minimize high drawdown. Numerical modelling (MODFLOW NWT version) was applied in order to develop a regional groundwater flow model for the Wadi Araba Basin. The modelling area covers 6268 km2 (the Wadi Araba Basin on the Jordanian side). The cell sizes in horizontal directions are 500 m, and there are four layers in a vertical direction represented by the main aquifers and aquitards of the hydrogeological system (alluvial aquifer, A7/B2 carbonate aquifer, A1-A6 marly aquitard and Kb/Ram sandstone aquifer). Results of the modelling show that renewable groundwater resources stand at around 20 million cubic meters per year (MCM/year). According to the most pessimistic predictive scenario, the water table might decrease by 60 m by 2050, with the most optimistic scenario putting that figure at 24 m. Five new wellfield locations are proposed (four in the central part and one in the northern part of the Wadi Araba Valley). According to the model, the opening of new wellfields in these optimal locations, and the closing of some old wells where relatively large drawdowns were recorded, revealed that a more sustainable abstraction of groundwater could be achieved.

Towards real-time forecasting of natural gas production by harnessing graph theory for stochastic discrete fracture networks

In this work, we compare hydrocarbon production curves obtained from a graph-based reduced-order model with the high-fidelity Discrete Fracture Network (DFN) predictions for a fracture network created using data from a real shale site. We observe that the bounds for the high fidelity DFN model lie within the bounds for the reduced order model, implying that the reduced-order model provides a conservative estimate. Moreover, we found that except for first-passage times and late arriving mass, the production curves from the reduced-order model predict transport accurately. However, it is to be noted that the results are inspite of trading a three-dimensional geometry for a reduced system in the form of a graph, one that is 500–1000 times faster in terms of computational efficiency (for this particular application). In addition, we also compare the production curves for large drawdown and small drawdown using our graph approach. The reduced-order model is successful in showing that the long term productivity is higher in case of small drawdown although the initial productivity is higher for large drawdown. Thus, this reduced-order model offers great potential in uncertainty quantification for production, as well as in providing operators with information to make real-time decisions for optimal production.

Groundwater modelling of the Tebessa-Morsott alluvial aquifer (northeastern Algeria): A geostatistical approach

This paper studies aquifer's hydrodynamic behavior by combining a flow-simulation model with transmissivity optimization (cokriging) in order to provide an optimal management scheme for the groundwater aquifer. The use of a cokriging approach improves the transmissivity data which are insufficient for the database of the groundwater flow simulation model. The obtained results are then used to model the groundwater flow of the Tebessa-Morsott shallow aquifer, located in NE Algeria, under a steady and transient regime. The results of the model calibration for the steady-state (year 2010) show that the recharge by rainfall and leakage rate are similar compared to those calculated by the analytical approach, (84,354 m3/day for the recharge and 36,986 m3/day for pumped water flow rate). The results of the transient regime show the alluvial aquifer affected by large drawdowns reaching 40 m over 20 years (year 2030 scenario) due to increase in water exploitation from pumping wells to answer water needs of the Tebessa region.

Predicting hedge fund performance when fund returns are skewed

AbstractWe show that fund‐specific return skewness is associated with managerial skill and future hedge fund performance. Specifically, skewness in fund returns reflects managerial skill in avoiding large drawdowns. Using a new measure of investment skill that accounts for this managerial ability, we demonstrate that traditional performance measures underestimate (overestimate) managerial performance when returns exhibit positive (negative) fund‐specific skewness. Our new measure is particularly valuable during periods of economic crisis, when the annual risk‐adjusted outperformance is 5.5%.

Analysis of the dynamics of gross domestic product and external economic activity of the Russian Federation for 2013−2018

Currently, the Russian Federation is a significant geopolitical and economic player in the modern global world, it has its own interests and traditional partnerships with most states, including business representatives of those countries that are trying to restrain its development through restrictions and partial isolation from global development opportunities . Despite the sanctions and the unfavorable world market conditions, the Russian economy showed high plasticity, stability and adaptability to external changes, which was reflected in the positive dynamics of foreign trade growth in the existing conditions. Therefore, the purpose of this article was to conduct a comprehensive analysis of the dynamics of official statistics on economic growth and foreign trade in the Russian Federation for the period 2013-2018. To achieve this goal, the following tasks were solved: 1) an analysis of the dynamics of the gross domestic product of the Russian Federation for the period 2013-2018; 2) the role of foreign trade in the gross domestic product of the country is estimated through the calculation of foreign economic quotas; 3) analyzed the dynamics of foreign trade, imports and exports of the Russian Federation; 4) revealed the shares of product groups in the structure of exports and imports, as well as the most significant counterparties of the Russian Federation. The hypothesis of the study was the thesis of the interdependence of the volume of economic growth and foreign economic activity, including taking into account changes in foreign economic conditions. The article provides a retrospective analysis of the dynamics of economic growth in terms of nominal value and purchasing power parity, as well as the dynamics of foreign trade of the Russian Federation for the period 2013-2018. A preliminary forecast of foreign trade volumes for 2019 is given. The calculation of foreign economic, export and import quotas for the same period. The Russian specifics of the dynamics and structure of export supplies and import flows, as well as the structure of both imports and exports by counteragent countries and enlarged groups of the commodity nomenclature of foreign economic activity, are examined. For the period under review, the nominal GDP fell by 28.8%, while in terms of purchasing power parity, the Russian economy grew by 5.7% over the same period. At the same time, the largest drawdown in the economy occurred in the middle of the period; in recent years, the situation in the economy has improved. The role of foreign trade in the formation of GDP during the period was relatively stable, with the exception of 2018, when the foreign trade quota sharply increased (as well as export and import). The dynamics of foreign trade and export quotas in the Russian Federation are almost identical, while imports depend on export earnings. For the study period, foreign trade turnover of the Russian Federation decreased by 18.4%, export volumes decreased by 14.8%, import purchases decreased by 24.5%. The main problem of the economy and foreign economic activity remains its dependence on the export of mineral products.

Detecting Changes in Asset Co-Movement Using the Autoencoder Reconstruction Ratio

Detecting changes in asset co-movements is of much importance to financial practitioners, with numerous risk management benefits arising from the timely detection of breakdowns in historical correlations. In this article, we propose a real-time indicator to detect temporary increases in asset co-movements, the Autoencoder Reconstruction Ratio, which measures how well a basket of asset returns can be modelled using a lower-dimensional set of latent variables. The ARR uses a deep sparse denoising autoencoder to perform the dimensionality reduction on the returns vector, which replaces the PCA approach of the standard Absorption Ratio, and provides a better model for non-Gaussian returns. Through a systemic risk application on forecasting on the CRSP US Total Market Index, we show that lower ARR values coincide with higher volatility and larger drawdowns, indicating that increased asset co-movement does correspond with periods of market weakness. We also demonstrate that short-term (i.e. 5-min and 1-hour) predictors for realised volatility and market crashes can be improved by including additional ARR inputs.

The Case for Risk Managed Gold

The strategic case for gold revolves around its long history as a store of value. Humans have been drawn to the yellow metal despite its inability to pay a dividend or provide productive output ownership since somebody first discovered it. From an investment perspective, gold has demonstrated an ability to provide a long-term source of uncorrelated returns while also serving as something of a flight to safety hedge during geopolitical or fiat instability periods. While there are plenty of speculators looking to gold as a source of potential outsized return, most of the investing public looks to gold at the intersection of those two objectives: risk management. The authors make the case that there is a risk premium for investing in gold, understanding that even though gold does not provide a stream of future cash flows paid out to investors, it has genuine utility as a store of value. The authors also explore the benefits of managing gold exposure in investment portfolios to manage large drawdowns through systematic momentum measures.