Are you taking enough risk? How do you know?

A low volatility and interest rate world has prompted a reassessment of the appropriate level of risk that is required to achieve a specified return outcome.

As investors seek returns in this anaemic world, absolute return funds come under the spotlight because they are typically structured to deliver an attractive return with lower than equity-level risk.

This dual focus on return and risk can also bring scrutiny as many critics are concerned about the promise of a “free lunch” – can one achieve a long-term, risk asset-like return and deliver it with a low standard deviation.

In other words, are you taking enough risk to achieve a return target and, importantly, how do you know?

• We believe that high information ratios – high returns for a given level of ex-post volatility – are possible if a manager can achieve a positive and persistent hit rate and a positive return skew, provided the risks interact in such a manner as to achieve low portfolio volatility.
• Standard deviation, VaR, tracking error and other risk metrics have become synonyms, or even direct substitutes, for risk. But, fundamentally, they are not the same thing.
• A volatility target put in place to limit downside exposure does not equate to the risk required to achieve a desired level of return. Low day-to-day volatility achieved through high levels of diversification allows portfolio managers to manage and limit short-term downside risk (drawdowns). However, it is the amount of internal risk – the risk associated with the individual positions or ideas – that allows the portfolio manager to achieve return targets.
• Put another way, portfolio returns are not an outcome of the level of assumed volatility but rather of the skill of the manager in selecting positions and combining these in portfolios – volatility is merely an outcome of how the assumed risks behave.

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