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The Prisma platform helps investors to better manage market extremes and offers risk indicators that enable them to manage their equity exposure and generate consistent and robust returns. Currently, Prisma offers 5 distinct indicators, all based on various and complementary economic or financial data, which provide a particular advantage on the markets. In this article, we present the Equity Risk Indicator (ERIC) which is an arithmetic average of the 5 Prisma indicators. We explore the potential of ERIC, its performance, and its advantages.
As explained above, the indicators available on Prisma are based on different alternative data sources and each indicator has its own reactivity and behavior:
To have a better vision of these indicators and their performance, you are invited to discover them on Prisma.
Each of the above indicators is appropriate for a particular type of situation. A simple solution for combining indicators is to weigh them equally in a final indicator, which is the methodology to obtain the ERIC indicator. ERIC represents a daily value between 0% and 100%, indicating the proportion of the portfolio that should be held in cash. Let us now assess how this indicator has performed in the past.
The following graph shows the performance of applying ERIC to the S&P 500 Index since January 2008 compared to a naive hedging strategy where half is invested in the S&P 500 Index and the other half in cash.
ERIC reduces the maximum drawdown of the S&P 500 index to -14%, while the naive hedging strategy has a maximum drawdown of -29.1%. Moreover, ERIC allows doubling the return of the benchmark while volatility remains at the same level of 10%, doubling the Sharpe ratio of the naive strategy. Beyond long-term outperformance, robustness and regularity are the main advantages of a balanced indicator like ERIC. Therefore, let’s take a look at the annualized returns over different three-year periods of our two strategies.
The statistics are appealing. Even when the balanced portfolio (50/50) manages to generate positive returns over all periods (especially in the 2008–2011 period), the returns of a dynamic equity exposure to the S&P 500 Index with ERIC are stronger and more regular over the years, especially in turbulent times. This stability makes ERIC a solid investment indicator to tactically reduce equity exposure in uncertain times.
For simplicity, the examples used in this article assume that investors can dynamically adjust their equity exposure from 0% to 100%. We are aware that these conditions are not always met. In further articles, we will illustrate how ERIC can be tailored to specific investment constraints, e.g. for multi-asset portfolios or when investors need to maintain a minimum equity exposure.
Next, we look at two specific time periods to delve deeper into the dynamics of the ERIC indicator and understand what diversification between indicators achieves. To better assess the benefits of the indicator, we compare the S&P 500 index using ERIC to the S&P 500 index that we buy and hold.
The first period we will focus on is the financial crisis of 2008.
While the actual market collapse took place in September 2008, the indicator already showed a high to very high risk at the beginning of 2008. The number of signals analyzed provided a global overview of the underlying economic risks. During this period, medium-term indicators such as the macroeconomic indicator and the momentum indicator performed particularly well (the momentum indicator recommended 0% equity exposure from January 2008 to May 2009). In these circumstances, a diversified indicator such as the ERIC indicator can benefit from the strength of its underlying indicators and provide great protection.
Let us now turn to a very recent and atypical period, the COVID-19 crisis, in which ERIC was of great interest.
The main benefit of the ERIC indicator becomes clear when analyzing the statistics of our two strategies over this period. The ERIC indicator reduces the volatility and maximum drawdown of the S&P 500 index to a third, while improving the total return, thus significantly increasing the Sharpe ratio over this period. During the COVID-19 period, the ERIC indicator was driven by volatility indicators such as the Vega and Spike, which were able to detect the impending crash due to their reactivity. The diversification inherent in the ERIC indicator allowed for a timely reduction of the equity exposure.
Finally, we come to a very recent period, namely the turbulent beginning of 2022.
Since the beginning of 2022, the ERIC indicator has significantly reduced the maximum drawdown of the S&P 500 Index from -18.7% to -10.3%, showing its strong impact in turbulent times. In terms of absolute returns, the S&P 500 experienced a decline of 12.7 %, while an actively managed portfolio with ERIC achieved a return of -7.8 %, outperforming the index by 5%. The chart above shows that the most volatile periods this year were clearly identified as “very risky” periods (dark red shaded areas). By reducing exposure to these periods, ERIC was able to reduce annualized volatility by more than half.
This content is advertising material. This content as well as all information displayed on Prisma or any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions, or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.
Alquant, a Swiss Fintech and quantitative asset manager, is transforming asset management with innovative solutions. Leveraging deep financial and technological expertise, we offer a range of services including investment products, quantitative research, and software solutions, empowering financial institutions to create the financial products of the future.
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