The volatility has now got so great that some are comparing developed markets to those of the emerging world. “Recently the UK has become more and more like emerging markets – as has the US – in terms of volatility,” says Richard Boardman, the head of risk at ISIS Asset Management.
Much of this volatility can be attributed to the Technology, Media and Telecoms (TMT) sector. The exceptional turmoil in the TMT sector has increased the market average.
But other sectors have also become more volatile. A switch from investment in “growth” companies (ones which promise higher than average earnings growth) to value shares (which are cheap relative to the market) has also contributed to volatility. As growth has gone out of fashion so value has enjoyed a renaissance.
Risk management
So investment management groups spend a large part of their time monitoring and controlling the risk of their portfolios. Sometimes this will be done by the fund managers themselves but often they will have specialist risk management departments to help do their job.
Of course there is nothing that fund managers can do in the event of a global meltdown of the financial markets. But in anything short of this nightmare scenario it is usually possible to at least mitigate the effects of financial volatility.
Even problems in one market or region can be counteracted. For example, it is possible to invest in an international fund which invests in a spread of different regions. So if, say, Japan rises when Britain falls the manager can use this fact to protect investors against the impact of a fall in the UK market.
In this sense diversifying between countries is similar in principle to doing the same with shares. “Individual countries, just like shares, don’t move exactly in line with each other. So gains in one can offset losses in another,” says Lucinda Corby, an investment strategist at ISIS.
However, many experts argue that as the world becomes more globalised it is more difficult to get diversification by investing internationally. A sudden change in the American stockmarket, for example, is liable to precipitate similar changes elsewhere.
Integral to funds
But it would be a mistake to attribute the current emphasis on risk management with recent volatility. Although the focus on risk management has increased recently it has always been an integral part of managing funds.
Investment funds are at least as much about managing risk as obtaining rewards. The best funds are carefully constructed portfolios rather than simply collections of shares that the manager likes best.
The fund manager’s job is largely to choose shares that will complement each other. So problems in one area should be counteracted by growth in another.
To take a simple example, imagine a portfolio consisting of just two sets of shares: one company making umbrellas and another making sun tan lotion. If it is constantly raining – a problem British investors are no doubt familiar with – the umbrella manufacturer will probably do well while the maker of sun tan lotion with suffer. But if it is sunny all the time the reverse will probably be the case. Either way the fund manager can play one off against the other as a way of hedging risk.
Another way to understand this process is by analogy with strong sports teams. The best football team, for instance, would not consist of 11 David Beckhams. Instead it would have a balance of players who were strong in different positions and whose skills complemented each other.
Risk essential
The key point for the investor to understand is that it is necessary to take risks to achieve rewards. In this sense risk should be seen as a factor to be taken into every investment calculation rather than a problem.
Those who are unhappy with the prospect of losing a significant portion of their investment would probably be better off in cash - such as high interest savings accounts – or bond funds.
But those who are prepared to accept the risk of losing a proportion of their assets in return for potentially greater rewards are more likely to invest in shares. Even here there is a risk spectrum. There is a big difference between investing in blue chip companies in developed Western markets and investing in an emerging markets fund.
The risk calculation for the individual investor should also take into account the investor’s time horizon. If an investor has savings of £5,000 which he needs to pay for a deposit on a house in a year’s time it would probably be best to keep the money in cash. But if the same investor wants to fund his retirement in 20 years’ time the short term volatility of the markets is less important.
Ultimately fund managers should be judged by the way they manage the delicate balance between risk and reward. It is not difficult, with some luck thrown in, for a manager to make a high return by punting on a few high risk shares. But achieving a reasonable return for a controlled level of risk is a more difficult and arguably more considerable task.
Morningstar risk management tools
Morningstar.co.in includes numerous tools to help investors examine the risk of funds in which they invest. These include specific measures of risk and indicators which include an element of risk.
Several measures of risk can be found on the Rating and Risk section in each individual fund's Quicktake report. For those who prefer a simple graphical representation there is a box which ranks a fund according to whether it is low, medium or high risk. But those who want access to more mathematical measure can look at several including:
* Alpha – the amount by which a fund has outperformed its benchmark taking into account its exposure to market risk.
* Beta – a measure of a fund’s sensitivity to market movements.
* R-Squared – the percentage of a fund’s movements that can be explained by movements in the benchmark index.
* Sharpe ratio - a measure of reward per unit of risk. It is named after William Sharpe, a Nobel prize winner in economics.
* Standard deviation – a statistical measure that can be used to quantify the volatility of a fund, that is the extent to which its price goes up and down.
It should be noted that alphas and Sharpe ratios are measurements of performance as well as risk. Both are ways of measuring how a fund or security has performed relative to the risk taken.
In every case it is important to remember that these measures change over time. Just as in the price of shares it is possible for volatility – or other measures of risk – to go down as well as up.
Risk is also included as an element of other measures on the site. For example, Morningstar ratings are partly based on risk-adjusted returns so, by definition, take risk into account as part of the overall calculation.
For further details see the Morningstar glossary and the Morningstar ratings section in About Us.
