Market Overview - Managing Downside Risk

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“You make most of your money in a bear market; you just don’t realize it at the time.”

– Shelby Davis, famed value investor

Executive Summary

  • The decade-long bull market ended when markets fell into bear territory in March
  • With volatility reaching highs not seen since the Great Financial Crisis, investors should have a heightened concern for risk-adjusted performance
  • It is important now to understand the value of downside protection
  • Since inception, our Small and Smid Cap strategies have consistently protected capital in down markets.

Introduction

From a personal perspective, times of crisis like these provide opportunities to evaluate priorities and focus on loved ones. From a portfolio perspective, it is a true test of our risk controls and a reminder of why we invest in quality companies. Given the impossibility of timing markets or knowing the market impact of unpredictable events, we feel a great responsibility to structure our portfolios in a manner that provides our investors downside protection relative to the market during times of turmoil. As volatility has spiked in recent weeks, we have been given a great opportunity to strengthen the quality of our portfolios by adding to our higher conviction holdings and investing, at what we believe are great prices, in new companies that we believe will manage their businesses well, regardless of the length or effects of the coronavirus.

Our portfolios have a quality bias that, at times, has caused us to underperform some of markets’ upside. However, this quality bias has consistently allowed us to outperform in down markets, as they are doing now. This approach has allowed us to outperform in both the short- and long-term for our investors.

Good vs. Bad Volatility

In volatile markets, investors should have a heightened concern for the risk-adjusted performance of their trusted money-manager. Because most volatility metrics for a portfolio (standard deviation, beta, etc.) do not differentiate between upside volatility (good risk) and downside volatility (bad risk), they often do not provide the insight needed to fully appreciate the downside risk of an investment.  We believe two of the better measurements to understand downside risk are the Sortino Ratio and Downside Capture.

Sortino Ratio (Absolute Downside Risk)

The Sortino Ratio only considers the standard deviation of the negative returns (downside deviation) of an investment. In comparing a portfolio to its benchmark, you want to see a higher ratio for the portfolio, as a higher relative ratio implies less downside volatility than the benchmark. As shown in the table below, our Small and Smid Cap portfolios historically have experienced less downside variability than their benchmarks and peer universes, as defined by these Morningstar categories.

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IMG_AM_Sortino_Ratio_2020_03_31

Sources: RMB Capital, Zephyr StyleADVISOR, Morningstar Direct

Downside Protection (Relative Downside Risk)

Having just experienced the fastest market drop into bear market territory in U.S. history, the Downside Capture of investment strategies has become a critical component of investors’ ability to recover their losses. 

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IMG_AM_Downside_Upside_Beta_2020_03_31

Sources: RMB Capital, Zephyr StyleADVISOR

Minimizing drawdown is critical due to the simple fact that you need a much stronger upmarket to recapture downside losses. For example, consider a market that drops -42% (as the Russell 2000 Index did from it’s high to low during the first quarter of 2020), then recovers with a +60% return. Assume an index and strategy begin that period with $100 each and apply the RMB Small Cap Core ITD upside capture of 96% and downside capture of 86% to the strategy’s returns. We know that an upside capture of 96% hurts on the upside – implying the strategy will underperform by 200bps in this example’s rebound. What we find is, on the downside, the index value drops -42% to $58.00 while the strategy returns -36%, resulting in a $63.88 market value. At this point, investors don’t feel great about the market value loss, but they do like seeing that their strategy outperformed the index by +6%. When the index rebounds +60%, its market value increases from $58.00 to $92.80. Assuming the strategy’s 96% upside capture (remember 100% upside capture is the breakeven point), we would see a +58% return for the strategy, with the market value increasing to $100.67.  While investors are likely unhappy with underperforming the upside by 2%, they have now recaptured 100% of their losses while the index has not. When geometrically linking the two performance periods together, the strategy in this example outperforms the index by 8%.

This illustration shows that it is more beneficial to outperform on the downside than the upside. For that market drop of -42%, the index would need approximately a +73% return to get back to its initial investment value. 

Quality Bias

With increased uncertainty in the future, quality factors start to manifest their value. When we think of quality, we think of management teams capable of leading their firms through both the good times and bad. We have found these management teams typically operate with less leverage on their balance sheets, which better enables them to adapt to changing market conditions and maintain their long-term strategic goals.  As of the week ending March 6, 2020, there wasn’t a significant trend in how leverage was impacting a stock’s performance from late February, when the recent sell-off began. Everything was down, which is expected when markets panic. Although caution still abounds, panic selling seems to have dissipated, as some investors are capitalizing on lower valuations. Since that second week of March, we have seen companies with lower debt ratios outperforming more highly levered companies, this trend is especially evident in the small cap space. 

In the table below, you see the performance by leverage bands for the Russell 2000 and 2500 Indexes for the month of March. Our Small & Smid Cap strategies are overweight quality (less levered) companies, which has a provided a significant benefit. 

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IMG_AM_Total_Debt_as_Perc_Total_Cap_2020_03

Sources: RMB Capital, FactSet

As markets continue to deal with uncertainty, we would expect this trend to continue, with capital flowing toward companies with strong balance sheets, lower leverage, and stable earnings.  
 

Summary

Since inception, our Small and Smid Cap strategies have consistently protected capital in down markets, outperforming their benchmarks 82% and 80% of quarters when the index had a negative return, respectively. These numbers include the most recent quarter, in which both strategies outperformed by over 400bps gross-of-fees. Detailed below is a collection of charts showing how our RMB Small Cap Fund (RMBBX) has performed through previous viral outbreaks.

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IMG_AM_Small_Cap_in_Past_Virus_Outbreaks_2020_03

As we eagerly await new information about our collective ability to defeat COVID-19 and the economic impacts of its disruption, we are relentlessly looking for opportunities to strengthen our portfolios. We believe our current environment provides an incredible opportunity for active managers to add value.  Bear markets are a painful, yet necessary, part of the capital allocation process, which punishes poor stewards of capital while rewarding good stewards, and ultimately strengthening the financial markets.  We will continue to strive to actively position our investors for an eventual recovery while maintaining the integrity of our quality bias. We are grateful to be part of the capital allocation process and are excited about the continued opportunities to add value for our clients.