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.

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In the previous article, we explored the structure and general performance of the ERIC indicator, the combination of all 5 indicators. In this article, we will conduct a more detailed statistical analysis of its functioning to get a better understanding of what such a risk indicator is capable of. The study period for this article is January 2008 to June 2022.

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Equity risk levels

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The way Prisma’s indicators work is simple. Our indicators (for example ERIC) range from 0 to 100%:

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1. If the indicator has a value between 0 and 24%, the risk level is low.
2. If the indicator has a value between 25 and 49%, the risk level is moderate.
3. If the indicator has a value between 50 and 74%, the risk level is high.
4. If the indicator has a value between 75 and 100%, the risk level is very high.

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The ERIC indicator displays low to moderate risk about 80% of the time and therefore does not deviate significantly from its underlying. In the remaining time when rare tail events occur, this indicator offers high added value. Thus, ERIC does not require to be constantly monitored.

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But do these risk levels provide information to distinguish different S&P 500 index regimes? The following table illustrates the returns and volatility of the S&P 500 index according to the different risk levels of the ERIC indicator from the previous day.

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We see that the annualized returns for the very high risk levels periods correspond to -32%. Only in 6% of the cases, does the ERIC indicator display a very high risk level. By avoiding these rare periods, we can significantly reduce losses. Furthermore, the volatility of these periods is correlated with the risk level, which confirms that this indicator seems relevant for identifying turbulent periods and stability of the S&P 500 index in the short and medium term.

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Let us now look at some additional statistics:

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The Sharpe ratio, which can be considered as the risk-adjusted return, is particularly high at low and medium risk levels. It is not meaningful at very high risk levels, as the returns of the S&P 500 Index are negative. Furthermore, it can be noted that in the periods classified as low or moderate risk, the maximum drawdowns of the S&P 500 Index are particularly low, indicating that these periods were solid and allowed for full exposure and investment in the S&P 500.

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The chart below shows the normalized distribution of the returns of the S&P 500 Index according to the previous day’s risk level. The blue distribution corresponds to low or moderate risk levels, and the red to high and very high risk levels. It can be seen that the returns on very high risk days are extremely volatile compared to the other regimes. These periods should be avoided at all costs by investors seeking solid and regular performance.

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Performance analysis

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Now that we have seen the ability of the ERIC risk indicator to identify different regimes of the S&P 500 index going forward, let us explore its value add from another perspective, by analyzing the drawdowns. The following graph shows the drawdowns of the two strategies. It quantifies the declines and the bumpy ride that investors have to sit through over time. The representation is quite tangible, as it reflects the common psychological bias that investors tend to anchor on the last maximum price and develop regret when prices fall thereafter. A new all-time high is reached when the curve is at 0%.

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We can see that, unlike the S&P 500 index which experiences regular and deep drawdowns, the S&P 500 index using the ERIC indicator is exposed to smaller drawdowns and reaches a new all-time high more quickly. Using the ERIC indicator allows investors to achieve more consistent returns and shorten the recovery period after losses. Since the beginning of 2022, the drawdowns with ERIC have been about half that of the index.

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Historically, using the ERIC indicator the average exposure to the S&P 500 is about 70%. Let us compare its performance with a portfolio that is invested 70% in the S&P 500 Index and 30% in US Dollars.

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In terms of robustness and stability, the ERIC indicator performs much better than the S&P 500 with the same average exposure. This clearly demonstrates the ERIC indicator’s ability, as it is able to reduce the maximum drawdown of its benchmark to one-third and be less volatile, while outperforming it in terms of absolute returns, thus doubling the Sharpe ratio.

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Disclaimer:

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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.

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