Volatility has again become a staple in our regular diet of market news and investment analysis. The key global equity market indices have recovered most, if not all, of their losses after global equity markets declined precipitously in the first quarter of 2016 — by 10 to 15% in many cases.
Volatility is a bit like spice: A little adds much needed flavor to a meal, but too much can be disastrous. Volatility can be a positive thing for active investment management as it leads to the dispersion of performance, which in turn creates opportunities for managers to earn differentiated returns. When dispersion is low, there is little that differentiates top-performing active managers from their mediocre counterparts. The value of active management is often questioned in these environments.
On the other hand, volatility eats into returns through the insidious effects of volatility drain. For an average rate of return, the more volatile the return stream, the lower the compound rate of return you will actually earn (all else being equal). This is because volatility has an effect on the way investment returns compound over time.
For example, if an investor has a $100,000 portfolio (Portfolio A) that earns a 10% return in two consecutive years, it will have a mean return of 10% per year and a cumulative value of $121,000 after two years. Contrast this with Portfolio B, also funded with $100,000, which earns a return of 30% in the first year and -10% in the second year, for a cumulative value of $117,000 at the end of the two years. While both portfolios post a mean return of 10% per year, the compound rate of return will differ. Portfolio A earns a rate of return of 10% while Portfolio B earns only 8.2%. This difference is known as volatility drain: the negative relative impact volatility has on portfolio returns.
Because of volatility drain, it is important that portfolio managers dampen volatility throughout the market cycle, and that’s where active management becomes very important. An active approach requires that a manager pay close attention to portfolio risk measurement and have appropriate policies and procedures in place, along with a risk-aware culture, to actively manage the risk embedded in a portfolio to ensure it is aligned with the investment philosophy and skill of the manager. An active investment approach includes an explicit risk budget, which should be appropriately managed in the ongoing oversight of the portfolio.
In contrast, when you’re invested in a passive portfolio, you own the market. You own all segments of the market: the expensive segments; the highly volatile segments; the low quality segments. An active manager has the discretion to critically examine the market and decide which securities or asset classes are providing adequate compensation for the risk taken on. The manager can then choose not to invest in securities that are expensive or highly volatile. In other words, they can focus on dampening the risk through time by striving to reduce unwanted volatility.
The 2008–2009 global financial crisis taught us just how important risk management is in any investment environment, and that highly improbable events — “fat tail risk” — can occur fairly frequently. The absence of a strong risk management approach can expose investors to the vagaries of the uncertain and frequently volatile economic and geopolitical world we inhabit. Certainly something worth pondering.
By Joseph Flaherty, Chief Investment Risk Officer