Advisers should start talking to clients about the potential detriments of chasing sheer performance — and the importance of understanding how gains are achieved.
Will the U.S. equity markets keep going up at the pace of the last few years? Affluent investors seem to expect so — the Legg Mason Global Investment Survey showed 85% cited U.S. equities as the best opportunity over the next 12 months, up from 74% at the end of 2013.
However, those same survey respondents cited an increase in volatility as one of their top threats — and there has been an uptick in volatility recently. Volatility is not necessarily bad. In fact, it can bring opportunity to active managers.
It should be noted that the S&P 500 has not experienced a drop of 10% since 2011. Notwithstanding geopolitical concerns and the global decline in energy prices, the most recent “correction” in the S&P 500 did not exceed October 2014's 5% decline. But can that continue?
While not at the extremes of financial crisis periods, one measure of volatility — VIX — has increased.
A trademarked ticker symbol for the Chicago Board Options Exchange (CBOE) Market Volatility Index, VIX is a measure of the implied volatility of S&P 500 index options. Referred to as “the fear index,” it represents the expected volatility of the market's 30-day forward price. Typically between 10 and 80, since 2004 the VIX has averaged around 20.
It is also worth considering a “volatility of volatility” measure, the VVIX.
A key indicator of how much market volatility is expected to change, VVIX ranges have been between 60 and 145 and have hovered around an average of 86. A VVIX above 86 is considered above average and implies greater uncertainty in the market; below, less certainty is implied.
Think about the VVIX as a measure of the degree of confidence the market has in forecasts about future volatility (the VIX). In that sense it is the level of uncertainty about the level of uncertainty, which would arguably be a purer indication of underlying market risk.
VVIX is also increasing. While this does not necessarily mean we are heading for a major downturn, it is a potential warning signal that bears watching.
Financial advisers thus may want to start talking to clients about the potential detriments of chasing sheer performance — and the importance of understanding how gains are achieved.
How can financial advisers and clients judge a strategy's overall performance, by incorporating risk? Two relatively simple measures can prove determinative: the Sharpe ratio, and the Sortino ratio. Analyzing them is important to judging the actual performance of investment strategies.
Conceived by Nobel Laureate William Sharpe, the Sharpe ratio uses standard deviation to measure risk-adjusted investment performance. It can distinguish whether returns potentially resulted from skilled decisions or excess risk. A portfolio or fund may reap higher returns than its peers, but it arguably is a good investment only if those returns do not come with too much risk. The higher the Sharpe ratio, the better its risk-adjusted performance; negative Sharpe ratios indicate that risk-free assets would have performed better.
A Sharpe ratio variation, the Sortino ratio focuses on downside risk optimization. It removes the effects of upward price movements on standard deviation by measuring returns against downward price volatility only.
While both measure risk-adjusted returns, the two ratios' dissimilar constructions may lead to different conclusions on an investment's return-generating efficiency.
Let's draw an example, a simple 3-year analysis of two anonymous large cap portfolios that could be core positions in any portfolio, compared with the S&P 500.
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When looking solely at returns, the best investment was clearly Portfolio B.
Now let's consider standard deviation: Portfolio A showed the least volatility. By contrast Portfolio B produced the greatest volatility; this suggests, potentially, the greatest amount of risk.
Standard deviation allows us to calculate each portfolio's Sharpe ratio, or the return per unit of total risk. The higher the Sharpe ratio, the better.
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Under this metric Portfolio A performed best, followed closely by the S&P 500; Portfolio B trailed.
By breaking down the amount of risk one level further, we can tell an even better story. Standard deviation is a good measure of overall portfolio risk, but it can be skewed by both excessive positive returns and excessive negative returns. No one complains about excessive positive returns but no investor likes big losses. We can quantify the downside deviation: Portfolio A had the lowest (3.75), followed by the S&P 500 (4.69) and Portfolio B (5.33).
Downside deviation drives the Sortino ratio, which assesses return per unit of downside risk — again, the higher the better. This shows which manager balances the quest for higher returns while minimizing the potential for significant drawdowns.
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In this risk-adjusted analysis, Portfolio A wins, despite producing the lowest returns; Portfolio B and the S&P 500 produced greater total returns, but with more drawdown risks.
This demonstrates that when selecting managers for the long-term — especially during volatile market cycles — it is important to look at the full picture. Sharp and Sortino ratios can give smart financial advisers valuable insights, providing an easy way to assess (and convey) whether an investment strategy is adequately rewarding your clients for the risks their money takes.
Thomas Hoops is executive vice president of business development for Legg Mason.
