Issue: December 2007/February 2008
Getting to Grips with Investment Risk
Most people have a good feel for colloquial definitions of risk and an understanding that, intuitively, one should expect some extra reward for exposing oneself to an uncertain outcome. The ever-expanding number of tools and models made available to investors and their advisers, accompanied by a sea of jargon, makes it increasingly difficult for even experienced investors to understand the benefits and limitations of these measures. And using the wrong measure can lead to sub-optimal decision-making.
The importance of risk is not merely limited to the probability of outcomes being very different to expectations, but can be extended to the concept of risk-adjustment returned where the merits of different investments or the skill of underlying manager can be evaluated.
"it is increasingly difficult even for experienced investors, to understand the benefits and limitations of measurements of risk"
If you want to know how risky a portfolio is, simply check how volatile it is - this is usually represented by standard deviation.
Absolute risk and return measures
If a investment has an expected return of 15% and an annual standard deviation of 25% then, two thirds of the time, the fund's return is expected to fall between - 10% and + 40% (15% + or - 25%) in any given year. This measure becomes very useful in determining the likelihood of the underperforming or outperforming things such as inflation, interest rates or the value of initial investment.
Risk-adjustment return measures (such as the Shape ratio) use standard deviation as a measure of volatility to compare different investments on a risk-adjusted basis. This aims to determine whether the investor was compensated for taking additional risk compared to the alternative of investing in the "risk-free" asset, namely cash. Simply, it measures the performance of the portfolio relative to cash and adjusts this using the volatility and the underlying investments.
Relative risk and return measures
Active return, or alpha, simply measures the difference between the portfolio return and the benchmark return. Why should the benchmark return be relevant? The usefulness really lies in attempting to determine and attach some level of skill to the portfolio manager.
The question is whether the investor derived any value from having his portfolio actively managed after fees and, id so, how significant was the value added through skill? Put simply, did the portfolio manager generate excess returns by building a portfolio that is different to the benchmark? Logically, if the manager is skilful, the bigger the positions take relative to the benchmark, as measured by active risk or tracking error, the higher the expected excess performance over the benchmark. By measuring actual performance relative to the benchmark (alpha) and comparing this how aggressively his view was implemented (tracking error), one can develop a sense of how much nay excess performance had to do with skill. This is what an information ratio measures - the performance added relative to the size of the positions taken.
There are however some major pitfalls!!
What if, however, another portfolio manager sees the world differently? This manager may be more interested in generating the highest total return over time for the investor with little reference to the benchmark. Remember, this approach needs not result in a riskier portfolio. Here, a stock that has a weighting of 2% in the portfolio will be regarded as a positive 2% position regardless of the benchmark weight. If the manager doesn't like a share, it gets left out. In this case, a skilful may well generate superior returns over time for investors. However, as the stock weights may differ substantially from the benchmark (as positions are not being measured with reference to the benchmark, but relative to not holding the share at all), the manager will be seen to have taken substantial relative positions and may run a high tracking error. Hence, measures such as information ratios may in this case look relatively poor and give a very distorted indication of skill and value added.
What then are our conclusions?
"Using the wrong risk measurement tool can lead to sub-optimal decision making..."
Where the volatility of portfolios differs significantly within a sector, do incorporate risk for the basis of comparison. This helps us determine whether we are comparing apples with apples. You cant compare the performance of two portfolios when one has volatility of 15% and the other 5%. Where portfolios have similar volatility, you can compare returns. Where absolute return type portfolios have different risk profiles, it is valuable to use risk-adjusted returns such as Sharpe ratios to validly compare them.
Do not use concepts such as tracking error as a proxy for riskiness. This simply tells us how different the portfolio is positioned to the benchmark, not how volatile it is. Be careful about simply using information ratios (and the Sortino ratio, which uses downside risk relative to the benchmark) as a measure of skill - a skilled manager that does mot manage the portfolio according to active positions (difference to the benchmark) but simply on the absolute size of the holding of any security in the portfolio, will not be concerned with tracking error, which may directly and negatively impact the information ratio calculation.
Information ratios are very useful for determining the skill of the manager for portfolios that are actively managed around ratio calculation.
So, it's all about horses for courses - there is no holy grail. All of these tools have advantages and weaknesses; you need to know what they are if you are going to use them. When in doubt, fall back on good old risk (standard deviation) and return. You might surprise yourself how strong your intuition is, given simple and robust information. Equally, at a qualitative level, you can evaluate the strength and depth of investment teams and know by reputation which companies give you comfort.