Passive Aggressive - Measuring Risks of Passive Investing Using the Pain Index

The pain index is a vast improvement on maximum drawdown, which is a common measure of capital preservation. Maximum drawdown is defined as the peak-to-trough loss on an investment, but it only measures one dimension on the above graph. Maximum drawdown doesn’t tell us how long it took to recover our losses. Maximum drawdown doesn’t account for the smaller, secondary losses. An investment with an inception date post-March 2009 will have a very different maximum drawdown than one that experienced the financial crisis.

People frequently ask, “What is a ‘good’ pain index? What number should I look for?” Obviously the smaller the pain index the better. We want that area of loss to be minimized. As far as a concrete number is concerned, I like to answer that question by drawing an analogy to standard deviation. What is a good standard deviation? It depends. It depends a lot upon the asset class. Obviously asset classes like investment grade bonds will have a small pain index, since they rarely lose money. Conversely, asset classes like emerging markets will have a larger pain index since they occasionally experience significant sell-offs.

In the table below, we have indices representing many of the major asset classes, and the corresponding pain index and standard deviation for each.  Also on this table is Swan Global Investment’s Defined Risk Strategy.

Asset Class Return Standard Deviation Pain Index
Hedged Equity Swan DRS (net) 8.53% 9.65% 2.32%
U.S. Large Cap Stock S&P 500 6.85% 15.27% 12.03%
U.S. Small Cap Stock Russell 2000 7.93% 20.13% 10.23%
Foreign Developed MSCI EAFE 4.13% 17.03% 15.98%
Foreign Emerging MSCI EM 4.99% 24.04% 19.87%
U.S. Invest Grade Bond Barclays U.S. Aggregate 5.26% 3.46% 0.58%
U.S. High Yield Bond Barclays U.S. Corp. High Yield 6.90% 9.27% 2.50%
Commodities S&P GSCI -1.49% 23.08% 34.31%
Real Estate FTSE Nareit All REITs 9.05% 19.82% 11.72%

For nearly 20 years, Swan Global Investments has managed the Defined Risk Strategy (DRS) with the explicit purpose of minimizing the depth, duration, and frequency of losses.  By combining ETFs with the intelligent and efficient use of options, the DRS has been able to mitigate the impact of losses without sacrificing too much of the upside.  The graph below illustrates how the DRS was able to successfully weather the two major bear markets of the new millennium and generate a pain index roughly 1/5th of that of the S&P 500.

There are many different ways to measure risk. For passive managers, benchmark-relative measures are useless, since a passive manager is essentially the benchmark. If one is concerned with volatility, then standard deviation and the Sharpe ratio are useful metrics. But if one believes that the real risk in any investment is capital preservation risk, then the pain index serves as a useful addition in the analyst’s toolbox.

Marc Odo is the Director of Investment Solutions at Swan Global Investments, a participant in the ETF Strategist Channel.

[1] Full disclosure: From 2003 to 2014 I was the Director of Research at Zephyr Associates and had the pleasure of working alongside Dr. Becker and Aaron Moore.

Disclosure Information

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan Global Investments offers and manages the Defined Risk Strategy for investors including individuals, institutions and other investment advisor firms. All Swan products utilize the Swan DRS but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS  product  offerings  will  have  different  performance  results  and  comparing  results among the Swan products and composites may be of limited use. Swan claims compliance with the Global Investment Performance Standards (GIPS®). Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes nonqualified discretionary accounts invested in since inception, July 1997 and are net of fees and expenses. All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970.382.8901 or visit