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Why volatility fails as a measure of risk

23 April 2020

Volatility is a Vix-ing problem, which can lead to a ‘somewhat skewed sense of security’, says David Coombs, head of multi-asset investments, Rathbones.

The word ‘unprecedented’ has been thrown about a lot recently, and with good reason. The outbreak of Covid-19 is a situation unparalleled in our lifetimes in terms of its global and severe impact. Yet before this current panic, we had experienced yet another ‘unprecedented’ situation – namely, 12 years of relatively benign markets and central bank intervention.

Investors have lived in a new paradigm over the past decade. Previous income fail-safes are no longer a viable option, interest rates have been held at historic lows and equity markets continued an inexplicable rise – until recently.

It led to a reliance on alternative investments, and on travelling up the risk curve in the search for yield to produce income.

Another development, which followed the influx of regulation designed to look after the end investor, has been the proliferation of risk-rating agencies such as Dynamic Planner and Finametrica. These aim to guide advisers to choose between funds or model portfolios with the same risk characteristics, usually rated from one to ten. The ratings are based on the agency’s expectations of a fund or portfolio’s nominal volatility.

In relatively benign market conditions, as witnessed in the past decade where volatility has been low by historic standards, the re-rating of funds has been infrequent. Yet, there was always the risk that as soon as volatility returned – as it has with a definite bang in 2020 – the dispersion of returns from funds within the same risk rating could increase dramatically and lead to falls beyond investors’ expectations.

The key issue comes down to what we consider to be the best way to measure risk.

Many funds attempt to target nominal volatility to ensure they stay within the tolerances set by the rating agencies. The trouble with this is that when volatility inevitably begins to rise, these funds are forced to sell asset classes deemed to experience higher volatility (such as equities) and when markets recover and volatility falls, those same funds are forced to buy higher volatility asset classes at higher levels. They find themselves in the situation all should avoid, buying the market highs and selling at the lows.

Measuring risk based on volatility alone and the movements of the Vix is where the problems start. Volatility is not only a backwards-looking measure, it is also impossible to predict. Targeting nominal volatility essentially means trying to predict the movements in the Vix, an impossible act given it moves based on human characteristic such as fear, uncertainty and irrationality. These cannot be predicted. Nonetheless, measuring risk in this way has come to dominate thinking.

While risk ratings are useful to help advisers with finding suitable investment solutions, investors should be aware of managers relying on them to determine investment strategy or using the template asset allocation models as a benchmark.

The ratings can often lead to a somewhat skewed sense of security, something that is not challenged until a period of market stress. Often volatility can be gamed by investing in assets that price or trade infrequently. As we have seen, a significant market shock that causes investors to raise liquidity quickly forces those assets to be priced based on actual trading. Think of it as similar to selling houses – the property is only worth what a buyer is willing to pay for it, rather than an estate agent’s subjective valuation. When it comes to investments, this can lead to sharp drawdowns from assets that appeared to be characterised by low volatility. It is clear that low volatility does not equal low risk.

Rather than relying on volatility as the only measure of risk, investors should be disciplined in conducting their own due diligence on the liquidity and diversification of the underlying assets in a portfolio. This involves a consideration of how the price of one asset is expected to change in relation to the price of another and an understanding of how different assets behave in diverse market conditions. The expected drivers of asset values will also be different depending on the scenario – understanding and managing these factors is a far better way to assess a portfolio’s risk.

Targeting volatility can mean that you will be forced into the wrong decisions at the wrong time, yet it has taken over as the go-to definition of risk in recent times. Over the period in which this way of thinking has become engrained, we also witnessed a startling lack of volatility – arguably driven by global quantitative easing – allowing the assumption that volatility equals risk to continue without being questioned or challenged. When the market turns, many of those funds targeting nominal volatility have struggled and funds rated cautious have turned out to be less cautious than they appeared. A lesson learned indeed.

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