“They’re looking for lower volatility, and they are paying a very heavy price for lower volatility: They’re losing performance.” –George Soros , Quantum Fund
“Risk is not volatility” – Mario Gabelli, GAMCO Funds
The Problem: A common assumption is that greater risk is required to achieve higher returns, but that is in a world where volatility equals risk. This misconception has become institutionalized by the prevalence of risk-return models (like Samuelson, Merton, and Markowitz’s mean-variance based Efficient Frontier). The basic question is, “how do you want to measure risk?” By how much something moves or how much you can lose? If we were measuring risk with volatility (how much something moves) you would find that a higher return has a higher risk. But volatility is not risk.
Fundamental managers gauge risk by measuring downside risk. For example, assume you have two stocks trading at $20 and you believe that both should be worth $30. If Stock #1 has a volatility of 20 percent and Stock #2 has a volatility of 30 percent, the gut reaction is that Stock #2 with the higher volatility, is more risky. But what if the downside, book value in this case, for Stock #1 is $10 and $15 for Stock #2? If we are equally confident in both investments, then Stock #1 with the lower volatility but lower book value is the riskier asset.
The Solution: Firms should employ risk-adjusted return to measure idea quality so that the perceived value of an asset will go down as risk goes up. To quantify the proof above, assume that upside and downside are equally likely at 50 percent. Then the risk-adjusted return for Stock #1 is 0 percent and Stock #2 is 12.5 percent. The higher risk-adjusted return is assigned to the lower risk asset.
This is the benefit of including downside risk in your return estimate. The inherent risk-adjustment of risk-adjusted return, combined with a repeatable decision process, creates a discipline that a fund will use to determine if an asset deserves to be included in the portfolio, how it will be sized, and how it will be adjusted as prices and fundamentals change. This does not mean that volatility should be ignored, but for fundamental managers it should be put in proper place behind downside risk, liquidity, sector exposure, etc.
Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and CEO of Alpha Theory™, a risk-adjusted return based Portfolio Management Platform provider.
