The pitfalls of volatility

Supported by
Aviva Investors
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Supported by
Aviva Investors
The pitfalls of volatility

In May, the Vix fell to 9.65, dabbling at the all-time low set by the index on 23 December 1993, when it was reading 9.17.

Michael Baxter, economics commentator at The Share Centre, notes: “Since the index was launched in 1990, the average reading has been 19.5. The index peaked in 2008 with a reading, at close, of 80.06, and closed at 42.99 on 10 August 2011. 

“However, over the last 12 months or so volatility has been low, with mild exceptions during the EU referendum and US election. The index closed at 25.76 on 24 June last year – a 12-month high and also rose over 22 for 24 hours or so a few days before the UK election.”

He explains: “The index, which is taken from a moving average of the S&P 500, is often referred to as the fear index – implying that right now the markets are very unafraid.”

Definition of risk

The world may appear to be in a remarkably stable period, with equity markets including the FTSE 100 and S&P 500 having made steady gains so far this year.

But volatility can be devastating to a portfolio which is exposed to too much downside risk.

The most common definition of risk in financial markets is the magnitude of short term fluctuations which is referred to as ‘market volatility’.Andrew Harman

A short-term bout of volatility in the markets may cause losses in a portfolio which is about to be drawn down by someone retiring, for example.

Andrew Harman, portfolio manager, multi-asset solutions at First State Investments explains: “The most common definition of risk in financial markets is the magnitude of short term fluctuations which is referred to as ‘market volatility’. This is only a one-dimensional view of risk. 

“We define ‘risk’ for the investor as the probability of not meeting their investment goals. The ultimate hazard to an investor is that they do not have enough income and/or growth to meet their current and future liabilities.”

Thomas Wells, fund manager for multi-assets CFA at Aviva Investors, suggests, from a client’s perspective, risk is losing money and not the volatility of returns.

“Despite this the finance industry is fixated with using volatility as a measure of risk to the extent that the terms volatility and risk are used interchangeably,” he notes.

“The majority of our investors perceive current market risk to be above average. This is hardly surprising given the busy political calendar in Europe and the uncertainties surrounding the current US presidency.”

But volatility levels at the moment are telling a different story entirely.

Figure 1: Rolling 3 year monthly volatility of the MSCI AC World index

 

The chart [see figure 1] shows volatility across global equities is currently at unusually low levels; in fact one of the lowest points in the last 10 years, he points out.

“The only way to reconcile  this difference between investors’ perception of ‘above average’ risk and the unusually low levels of volatility we are currently experiencing is by recognising that volatility is not a very good measure of risk.”

For Mr Wells, fluctuations in volatility are particularly problematic for portfolio managers targeting an absolute level of volatility.

He explains: “For example a fund targeting 20 per cent volatility in 2011 would translate to a portfolio consisting of 100 per cent global equity. Fast forward to 2017 and to achieve the same level of volatility the portfolio manager would have to either leverage the portfolio or increase exposure to more volatile and risky assets. 

“We believe that this type of volatility targeting leads investors down a dangerous road. During low volatile periods, such as now, portfolio managers would have to add extra risks in order to achieve an arbitrary volatility target.

“When a period of market distress materialises investors could lose more money than anticipated as portfolio managers are forced to sell risky assets in a declining market.”

Risk and reward

Mr Harman acknowledges: “The most common catchphrase for risk measurement in multi-asset is normally in relation to equities: ‘similar return with less volatility over an investment cycle’.  

“This measurement assumes that investors are only interested in reducing risk in comparison to equities, which may have an element of truth, although misses the point.”

It’s very important to look at the track record of multi-asset funds and where returns have come from in the past.Bill McQuaker

No investment is entirely free of risk but usually the more risk an investor takes, the more they may be rewarded with higher returns – although this is not always the case.

Altaf Kassam, EMEA head of strategy and research, in the investment solutions group at State Street Global Advisors, cites one pitfall of diversified investing which is correlations stop helping when it is needed most.

When correlations pick up, that’s when volatility often spikes and significant drawdowns can be very hard to recover from. 

He uses an example where a drop of 50 per cent in portfolio value needs a subsequent 100 per cent increase to get back to even.

“Thus, unmanaged volatility can be a drag on returns over the medium- to long-term,” he adds.

Mr Harman proposes a risk framework for advisers and investors to follow when evaluating multi-asset managers and their exposure to volatility:

  • Has the fund delivered the required return over the investment horizon? Achieving the investment return over the investment horizon is a key criteria in evaluating investments. Being too conservative could be risky as the fund may fall short of meeting its investment target over the long term.
  • How often do large capital drawdowns occur and how long does it take for the portfolio to recover? A drawdown is the peak-to-trough decline over a period for an investment. The maximum drawdown provides an indication of the worst loss one would have experienced had they withdrawn their capital at an unfavourable time in the market cycle. It is also important to examine how long the portfolio took to recover from the loss. The portfolio needs to work harder after a drawdown; a 20 per cent loss requires a 25 per cent return to recoup the losses.
  • How did the fund perform after adjusting for risk? The Sharpe Ratio is a measure for calculating volatility-adjusted excess return for a fund. It is calculated as the return earned in excess of the risk-free rate per unit of volatility. This provides investors with a tool to evaluate funds with similar return objectives and investment horizons.

Past performance

Many of the multi-asset funds available to UK investors have only recently launched and may not even have a five-year track record.

This means they may not have experienced any particularly volatile periods and so have not been truly tested, some might argue.

Volatility can impact returns, but investors should remember that it can also create good opportunities to add to positions if the fundamentals look good.Bill McQuaker

Bill McQuaker, portfolio manager of the Fidelity Multi Asset Open range, says: “It’s important to look at the track record of multi-asset funds. 

“For example, a multi-asset fund could have done  well by being long equities and credit over the past few years. But this won’t be any good if they don’t have other sources of return or can protect on the downside.”

He sees the next few years as a good test for the multi-asset industry in general.

It is also important to remember while volatility can result in downside risk, it can also create opportunities for highly skilled multi-asset managers.

“Volatility can impact returns, but investors should remember that it can also create good opportunities to add to positions if the fundamentals look good,” explains Mr McQuaker.

“The last time we saw this was in December 2015/January 2016. If you’d added to the S&P 500 at the bottom then, you’d have made around 30 per cent by the end of April this year.”

He believes: “Having a firm grasp of the fundamentals, especially the outlook for growth and central bank policy, together with an appreciation of evolving sentiment can make all the difference in situations like that one.”

The majority of investors in a multi-asset fund will have a long-term investment horizon, meaning they should be able to ride out short-term fluctuations in markets and asset classes.

But being aware of volatility and how it can affect a diversified portfolio of assets will make advisers and investors better informed.

eleanor.duncan@ft.com