Getting to grips with volatility requires a rethinking of risk

• Extensive due diligence is crucial to gain insight into how investment managers construct their portfolios

Investing by its very nature requires that managers take on some measure of risk. However, risk is a complex concept and how it is defined can affect the decisions fund managers make.

We believe the most crucial risk for most clients is not meeting their return objectives over the long term. This can occur because clients are invested in a fund that underperforms the objective (or experiences a permanent capital loss), or because a client exits a fund at the wrong time, due possibly to short-term underperformance, crystallising losses.

Asset managers must therefore strive to find a balance between maximising long-term performance and ensuring that short-term performance does not disappoint investors to such an extent that they divest. However, these objectives can frequently be in conflict.

US economist Harry Markowitz introduced

“volatility ” as a proxy for risk in 1952, but market participants only started thinking of volatility as risk after the 1987 Black Monday market crash. JPMorgan developed a report estimating the “maximum” the bank could lose on any given day. This used historical volatility as an input and led to the development of value-atrisk. In 1993 JPMorgan made its methodology freely available, leading to historic volatility becoming the de facto measurement of risk in the investment industry.

Actual portfolio risk is incredibly difficult to assess, so it is no wonder the finance industry has embraced one easy-to-calculate measure, despite its numerous shortfalls and flaws.

However, relying too heavily on volatility as a risk measure has significant drawbacks.

Historical volatility has a correlation with market moves — when markets fall volatility rises, while in bull markets volatility tends to flatline or decline.

Using volatility as a risk measure implies assessing risk as higher after a fall in the market (and rise in volatility). Conversely, it would imply risk is lower after a market rally. This is counterintuitive. We believe that the price you pay for an asset is a critical driver of both potential performance and the risk of permanent capital loss. Historical data supports our view.

Using volatility as a risk measure implicitly assumes market returns are normally distributed.

However, when comparing actual annual S&P 500 returns to a normal distribution with the same mean, it is evident that there are more actual observations around the mean and in the left tail than a normal distribution assumes. This, in turn, means many assumptions about risk based on volatility are flawed.

These assumptions can be even more flawed when volatility is used to assess the risk of multi-asset funds, which by design do not display normal payoff profiles. Focusing only on volatility ignores the distinction between desirable upside volatility and volatility associated with losses.

On occasion, funds seen as high risk due to elevated historical volatility are being unfairly penalised for lumpy upside performance. Downside deviation addresses this by measuring only the volatility associated with negative returns.

Ideally, investors should focus on risk measures consistent with their relevant time period. While monthly volatility may be relevant for selected investors, most investors in multi-asset or equity-centric funds have a longer-term time horizon.

Measuring risk based on monthly moves creates a shortterm focus with potentially negative implications for investors ’ ultimate returns.

There are many examples of instruments and funds that displayed extremely low volatility, were seen as low risk, but whose value dropped precipitously, sometimes to zero. Here are two high-profile examples: Credit Suisse’s Additional Tier 1 (AT1) bonds, which were written off by the Swiss Financial Market Supervisory Authority as part of the forced rescue merger with UBS in March 2023; and of the $65bn of purported client assets in Bernie Madoff’s Ponzi scheme, less than $15bn in cash deposits were returned to investors (a 77% loss).

Some funds and instruments apply opaque mark-to-market processes, which can result in artificially low volatility of returns.

We believe an excessive focus on volatility is currently contributing to demand for credit investments at unattractive spreads in the local market, and is also driving greater investment in illiquid bespoke products.

Volatility as a measure of risk is a potentially misleading indicator for funds that make extensive use of these instruments.

While historical volatility as a proxy for risk is clearly flawed, it is relatively simple and objective, and is likely to remain a key part of any investor’s due diligence processes. However, we believe it is crucial to consider risk holistically, with a quantitative and a qualitative assessment.

Leading multimanagers, institutional investors, discretionary-fund managers and sophisticated advisers all conduct extensive due diligence processes on investment managers, gaining insights into how they construct portfolios.

We believe this is crucial to ensure risk is assessed properly. In addition, while an individual fund may appear risky on a stand-alone basis, each fund needs to be assessed in conjunction with other funds it may be combined with in a solution.

This is particularly relevant for funds managed on a basis similar to those of PSG Asset Management, as we do not construct our funds using benchmarks or strategic asset allocations, and hence can add significant diversification benefits.

WHILE HISTORICAL VOLATILITY AS A PROXY FOR RISK IS CLEARLY FLAWED, IT IS RELATIVELY SIMPLE AND OBJECTIVE …