The first step taken when managing someone’s investment portfolio is to assess how much risk is appropriate for that person, which in most cases relates to a corresponding level of volatility. The reason for this is that, in a perfect world, every investor would simply want to maximise return, but the nature of markets is such that not everyone can realistically afford the associated risk. There is an endless amount of research out there to explain why, in my view, this is largely related to an inability to time their exit.
To illustrate that point, I have charted the returns on the S&P 500 Index and compared it with that of the Credit Suisse (CS) Hedge Fund Index over the past 20 years. This comparison is actually quite apposite, given the recent negative media coverage that questioned whether hedge funds have any investment merit at all, given their underperformance of S&P over the period shown in the graph below. Personally, I find the premise quite short sighted, not just because it implies that, because one section of a very specific market was superior over a specific period (the MSCI World index underperformed substantially by comparison) justifies disregarding everything else, but mostly because the two are quite simply not comparable from a risk perspective.
Looking at the statistics, the S&P500 delivered an annualised return of 7.6% with an annualised monthly standard deviation of 15.2%, whilst the Hedge Fund Index produced a mere 80 bps less per annum, at 6.4% volatility. In practical terms, this means that if one did not have the luxury of timing when to sell, hedge funds would have returned more than US equities 72% of the time. While the S&P500 experienced losses of 5% or more in 27 months during this period, hedge funds suffered such a drawdown on only three occasions, with a maximum decline of 19%, versus 47% for stocks. At one stage this meant that, even though you would have doubled your money in hedge funds over a decade, the instability of equities meant that if you had to sell at this point to cover any liabilities, you would have been down 30%.
The focus is thus not on absolute return at any given specific time, but who is consistently closest to target over time, which is why risk adjusting returns is crucial in accounting for variations in performance, and thus eliminating the risk of timing. The aim of this article is not to promote hedge funds, as the concept applies to everything. Having said that, this particular analysis is very much skewed in favour of hedge funds as an asset class, as the broad CS Index is made up of various sub-indices with vastly different return profiles, some of which are more volatile than equities. The reduced volatility numbers we see here is a result of the index being a diversified combination of sub-asset classes within a broader asset class. This once again proves the great power of diversification, something we believe in and rely upon greatly at MitonOptimal.Volatility Matters