Investors should never base a purchase or a decision on an asset’s volatility because it is a misleading and irrelevant figure, according to Rathbone’s David Coombs (pictured). 
The manager, who is head of multi-asset investments at the group, has been vocal recently about his aversion to alternative assets, which he says people have flocked to for their low levels of volatility and high yields.
However, he believes that many of these assets are undesirable because they’re too expensive and the yields aren’t high enough for the large amount of risk the investor is actually taking.
“A lot of alternative investments demonstrate low volatility, which everyone thinks is nirvana, but I never target volatility in any investment I make,” Coombs said.
“I think it’s a really flawed statistic because what volatility is so dependent on is both how often something prices and how that price is calculated, so if it’s based on subjective modelling like aircraft leasing, you’re reliant on someone setting a price objectively until one of those planes is sold, a bit like property if you think about it – property is relatively subjective and is based on transactions. But most funds are based on models.”
As a result, Coombs warns that investors need to be extremely careful about seeing low volatility as a desirable trait and that it can actually have a negative impact on portfolios.
For instance, he says that assets with a low volatility are likely to end up with a higher drawdown because they’re more sensitive to changes in valuation points.
“I think people forget that because often, although not in every case, low volatility masks illiquidity. If you think about AIM stocks that don’t trade for eight days the stock isn’t very volatile, is it? It doesn’t mean that’s the price, it’s totally misleading,” the manager continued.
Performance of indices over 10yrs
Source: FE Analytics
“The fact the whole industry post-RDR has moved to volatility targeting is hugely dangerous and it hasn’t been tested, because most of this has come out since ’08.”
“At no stage do I look at volatility in any investment or in any of my funds. I’m not interested. I’m totally focused on correlation and ability.”
Annualised volatility is one of the metrics that is accessible to investors that’s used to portray a fund’s risk level, alongside other ratios such as maximum drawdown, which measures the most money an investor would have lost if they’d bought and sold at the worst possible times, and Sharpe ratio, which measures risk-adjusted performance.
Meera Hearnden, senior investment manager at Parmenion, says that volatility is a key metric that she uses, but she appreciates that some asset classes such as bonds and property have shown low levels of volatility for a while.
Performance of sectors versus index over 3yrs
Source: FE Analytics
She is mindful that volatility is likely to rise over the coming months and years, and that it needs to be put into context of the markets we have seen since quantitative easing and the markets we are about to enter without QE.
“We are of course very conscious of how QE has dampened the volatility of some asset classes and are keeping an eye on this,” she said.
“Volatility is a good measure of risk but when used in combination with other metrics to measure downside such as the Calmar ratio and the Sortino ratio, it can be a more powerful tool. Using a combination of factors can lead to a much better understanding of a fund’s risk and volatility.”
The Calmar ratio of an asset is its annualised rate of return compared with its maximum drawdown – the worse the vehicle performs on a risk-adjusted basis, the lower the ratio is over the specified time period.
The Sortino ratio is similar to the Sharpe ratio, but is calculated using downside risk as the denominator instead of standard deviation.
It measures an asset’s return against ‘bad’ volatility rather than indicating excess returns to total volatility. Due to this, a large Sortino ratio suggests an asset is low risk – although as with any investment, past performance is no guide to the future.
Darius McDermott, managing director at Chelsea Financial, agrees that other metrics should be taken into account and that there is too much emphasis on pure volatility.
“When we look at funds we look at the number of stocks that they hold, their overseas and currency exposure, there is no straight forward simple metric and I would agree with David in that it’s not a case of one size fits all. Volatility isn’t the be all and end all of what you should look at, but I still think it’s something that needs to be considered.”
FE Alpha Manager Guy Bowles, who manages the Ingenious Global Growth fund, says that emphasis on risk has increased over recent years and that when he founded Ingenious Asset Management in 2003, many client managers and stocks brokers didn’t know the risks they were taking.
Now though, while people are more focused on their risk appetite, he says that volatility is not something that private clients tend to discuss.
“Getting the returns is really tricky, managing risk is not as hard as people make out sometimes. From day one here we defined risk quite simply as the chance you could lose money, and that’s probably what a lot of people mean about risk,” he explained.
“I have never sat down with a client and asked them what they think about risk for them to say, ‘I don’t like a volatility much above 6.3’, for example, I’ve never had that conversation with a client and I don’t think I ever will.”
Despite a seeming lack of emphasis on volatility from retail investors, the FE Research Team’s Tom McMahon (pictured) says that volatility is actually one of the best guides investors have to the riskiness of their funds, even if there are flaws with it and it shouldn’t be used in isolation. 
In fact, he says that there are some alternatives with good theoretical underpinnings but in practice add little value.
“You could look at downside risk instead, for example. Whereas volatility, or standard deviation, looks at the sum of the squared differences from the mean return and roots them, downside risk only calculates the difference between the mean and lower returns,” he explains.
“In theory this makes sense, as people don’t view making money as a risk. However, in practice there are very few differences in the results once you screen a collection of funds, and the difference in both absolute numbers and rankings in a peer group are unlikely to be significant enough to change an investment decision in most cases.
He added: “It can add value to a more sophisticated investment proposition, however.”
The fund analyst says that in reality, volatility is an easy-to-understand metric and there is evidence that both volatility and the rankings of volatility within peer groups are stable.
This means that while past returns are no guide to future performance, volatility is a useful guide to future relative volatility.
“However, it has to be used together with some attempt to understand the risks in the current markets and their future course, and how the funds in a portfolio will react,” he warned.
“Conditions in markets can change significantly in short periods of time, and there is little point in blindly picking low volatile funds and assuming they will be able to cope with what the future holds.”
