Volatility, like cholesterol, can be good and bad

In the beginning only performance mattered. Why buy an asset at 6 per cent per annum when you can buy one at 10 per cent per annum?

This was the logic of the boom years on equity markets. Sustainable whilst markets were rising, and nourishing to the "passive" school of investment advice led by the tracker and enhanced tracker mentality.

Unfortunately, the current century has been characterised by extreme market volatility. Now it matters that the likes of Markowitz and Kahnerman had, through their Nobel Prizes in Economics, been trying to bring to the public domain the importance of investors looking at a balance of performance and volatility.

In 1990, Markowitz, through his "efficient frontier" contribution to Modern Portfolio thinking, highlighted the need to mix portfolios with assets that have highly varied volatilities and Kahnerman through the rather obvious revelation that investors are more disturbed with losses than they would be happy with a similar gain.

It is this volatility/performance mix which has been latched on to by the macro-economic hedge fund managers.

I talked to Daris Delins, director of Fund Managers at Castlestone Management, in order to guide us through the volatility/performance conundrum. To be effective though, we do need to understand two things: risk and volatility.

"It goes without saying," says Delins, "that all investments are risky".

About risk

So what is risk? "There are many ways to describe this – standard deviation or volatility are typically used as a proxy for risk. Standard deviation of a portfolio/asset reports the tendency of returns to rise/fall dramatically over a short period of time. The higher the standard deviation, the more likely the portfolio/ asset will change direction, up or down, from its mean return."

Yet Delins points out that, "like cholesterol, there is good risk and bad risk". Come again? "Good risk is the upward spike in returns and bad risk is the downward spike in return."

Okay, regular savers investing in a falling market that recovers can claim that they are buying cheap, or cost-price averaging, but fund manager-speak is generally targeted at lump sum investment. Delins' points are aimed at capital investments.

Downside risk as measured by the Sortino Ratio seeks to express how often and by how much I could suffer large losses relative to my expected long-term return. The lower scores indicate huge downside potential, the higher scores indicating shorter distances between the peaks and troughs of volatility.

Delins then takes us through major asset classes in order to give us a handle on volatility. "Some will say that the least risky investment is cash in the bank. True in a sense, except when the inflation genie comes out of the bottle."

The chart indicates bonds as one of the better "low risk" investments. So, for the risk-averse, should we be running to the bond haven? "Bonds are traditionally seen as less risky, but in the short term they can suffer losses as well, as in 2003 YTD."

What about property? "Property generally comes out well against bonds and equities," says Delins, "but we need to be careful as property isn't traded every day, so the risk/reward ratios look more favourable. This is because property valuations typically are lumpy, every 6/7 years on average".

As a macro-manager it is the volatility of equities which Delins attacks the most. "As investors have seen in the past 5 to 10 years, the market gains made in the 1990s can quite easily turn into large losses if a stock market has high risk as measured by standard deviation and downside deviation."

The attack is endorsed by the box (which admittedly focuses on the US) and shows that equities have a marginally better performance than bonds, but substantially higher levels of risk.

Telling story

The Sortino comparisons in the box provide a telling story. "A Sortino ratio between 2 and 3 is generally sought after for the lower risk portfolios," says Delins.

Delins is naturally competing for equity money, but you can't argue with the temptation of the lower risk investor seeking lower volatility. They might also be keen to hear Delins' view that "the likelihood is that equities will gravitate back to their historical average risk of around 14 per cent with associated performance of 5-8 per cent per annum. It is quite possible that in the interim we see a period like the 1960s/1970s, one year averages plus 15-20 per cent, the next averages minus 10-12 per cent, the seesaw revisited".

This is the backdrop in which the macro-economic (rather than the long/short equity hedge) managers are confident that their approach will appeal to prudent investors.

The macro-hedge guys have been showing much less volatility than equities. Back to Delins to explain "one reason for this is that hedge fund managers are very focused on not just generating positive returns, but also preserving these returns when made. So when they start losing money they reduce their positions quickly. They also bank profits on the way up".

One more reason to recommend some sort of hedge exposure into every capital investment.

The author is the managing director of Mondial (Dubai) LLC