Giselle Roux: Volatility's return leaves many investors friendless, but here's how to use it
Most investors will at some stage hear the concept of risk-adjusted returns. Returns are transparent – income plus capital. Risk is a more nebulous concept. Typically it refers to volatility, or to be precise, the first standard deviation.
For the sake of it, let's call it the most likely range of returns. A 12 per cent annualised volatility in an asset that returns 8 per cent a year implies that anything between -2 per cent and 20 per cent is normal in a year. That said, there are plenty of occasions where markets are out of range as the first standard deviation only captures 68 per cent of the measured variance.
A low-risk measure may not be a good thing. If an investment declines by exactly the same amount every month, it will have no volatility or risk, given the way the phrase is used. Predicting volatility is even less exact than returns, yet the redeeming feature is that volatility tends to be, well, less volatile.
How does one make use of this in practice? A fund's standard deviation provides a guide on the possible return profile.
First, check if the fund volatility has changed over time. If so, is there a good reason? It could be driven by sector or regional preferences or it could be that the portfolio managers are inconsistent in their approach.
A high-risk metric may be due to a concentrated portfolio, which is not a bad thing, but signals that a longer time horizon may be important for such an investment.
The Sharpe ratio
A broad sample of funds shows that hedged managers have a 15.3 per cent to 10.2 per cent standard deviation based on three-year data, while unhedged funds can limit the lower end to 8 per cent due to currency offsets. That said, some of the higher volatility funds in the unhedged have the best return. The so-called Sharpe ratio, a measure of the level of return for degree of risk is a common metric. Potentially valuable, but use it with care, as low return and low volatility may not be the best option.
Fear and uncertainty is likely to drive some away due to the current rise in volatility, an unexceptional 13 per cent on an annual basis. Rather, what it should do is concentrate one's mind on the investments in the portfolio. Participation is no longer your friend. The glory days of unhedged global equities, with the typical predominance of the United States (and therefore $US) are fading fast. Investments will have to work for a living, and returns will be less spectacular, prone to pullbacks and more volatile.
The temptation is to then to have an opinion on what or where one should invest globally.
Of course, it's sensible to understand the background. Start with economic data. Most is simply noise; weekly or monthly statistics that rumble on and on. Trends are more important, yet the level of gross domestic product is a poor indicator. The rate of change in GDP is much better, unsurprisingly determined by the household spending, investment and the like. Inevitably themes emerge, run their course and adapt. Be it commodities, yield stocks, healthcare etc, there is the balance between concept and valuation.
Weak relative return
Fund managers may be behind, with or ahead of these shifting patterns. They may, therefore, race out in front in terms of performance, match the momentum or look stupid at times. That should not be taken as an excuse for performance. Those that logically argue their case and change if the facts change may still prove a worthwhile investment. Too often one gives up when there is a period of weak relative return.To come back to volatility then; taking the current cycle as an indicator, the going will be tough, a revisit of one's global investments is worthwhile. If the managers have done well, look atwhy that is the case. Is it coming from a few sectors, possibly a few stocks? Can they repeat that again? If so, are they behind or ahead of events, or simply showing they misjudge outcomes too often? Either you or your adviser should be able to answer those questions.