Fund managers shouldn’t order the hottest dish on the menu

3 April 2012 | By Neil Veitch

As a parody of British attitudes towards Indian cuisine, it was both accurate and damning. Indeed, in my younger days, I must confess that I judged a curry by both how quickly it made me sweat and how many pints of lager would be required to douse the flames in my mouth. Looking back, I realise that they were perhaps not the best yardsticks by which to measure the quality of the food. Having matured a little since then, it is frustrating to see investment professionals continually making a similar mistake on a regular basis.

Volatility is a term which is frequently misunderstood and misrepresented. In popular usage it is bandied about in an almost entirely negative light and has become conflated with risk. A highly unscientific search on Google shows that ‘volatility + negative returns’ yields over ten times as many results as ‘volatility + positive returns’. Yet, as all investors should know, volatility merely reflects the dispersion of returns and not their direction.

Apple’s stock performance over the past few years has been more volatile than that of General Electric’s. Although it’s safe to assume that investors would have preferred to hold the tech stock over the past few years; it is debatable whether Apple’s higher volatility means that it was a riskier investment. In portfolio management, a fund which consistently outperforms both its peers and the benchmark index will demonstrate greater volatility than one which generates average returns.

It hardly seems logical to view a fund as ‘riskier’ because its volatility is higher as a result of a sustained period of outperformance. While it’s impossible to argue with the mathematical calculations which derive volatility, it is fairly easy to counter the often unthinking analysis which accompanies it. Concentrated portfolios which are not constrained by sector or benchmark considerations, will always have an inherent amount of volatility. The challenge is ensuring that the volatility is ‘good’ (like Apple’s) and the downside risk is managed appropriately.

The focus on volatility as a measure of risk serves little purpose. Investors should be aware of the downside risks in their portfolios and conduct the necessary due diligence to fully understand where issues may arise. During the global financial crisis of 2008 and 2009, liquidity among small- and mid-cap stocks evaporated. Forced selling drove prices downward and meant that the declines were even greater than could have been justified by the gloomy economic outlook. While the volatility of those stocks did increase markedly, this was largely a result of the lack of liquidity in the market. Liquidity risk needs to be managed carefully, yet does not attract the same attention as volatility.

Investors need to ensure that the measures which they use to judge risk are appropriate and relevant. Using volatility alone could leave investors with an unpleasant feeling, a sensation anyone who has had the extra-hot vindaloo will recognise all too readily.

 

^{Neil Veitch is fund manager of the SVM UK Opportunities fund.}

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