Investors need to pay more attention to metrics such as the Sortino ratio that demonstrate a history of protecting on the downside, according to Columbia Threadneedle’s Colin Moore, who warns that a likely increase in volatility means that portfolios have to be constructed with risk/return trade-offs in mind. 
Investors have had to deal with high level of volatility over the past decade, with the global financial crisis of 2008 prompting huge losses across financial assets, 2011’s debt crisis sparking concerns that the eurozone would break up and more recent turbulence caused by high valuations, slowing Chinese growth and plunging commodity prices.
Over the past 10 years, the annualised volatility of global equities as indicated by the MSCI AC World index has been 14.25 per cent. During this time, there has also been a maximum drawdown – which indicates the most an investor would have lost if they bought and sold at the worst possible times – of 34.30 per cent while 46 of the 120 months have seen a negative return.
The below graph shows the 12-month volatility of the MSCI AC World over 520 weekly periods of the past 10 years. Although it’s clear that it is still nowhere near the levels reached at the peak of the global financial crisis, volatility has been creeping back up towards the levels seen during times of extreme market stress – such as the eurozone sovereign debt crisis.
12-month volatility of the MSCI AC World over 10yrs
Source: FE Analytics
Moore, the global chief investment officer of Columbia Threadneedle, believes that the coming decade will be marked by more volatility than investors might have grown used to of late.
“I believe average volatility will be higher over the next 10 years than the last 10 years and episodic spikes will increase in frequency because sustainable economic growth will be structurally lower and geopolitical risk higher than any time since World War II,” he said.
“Low growth creates uncertainty while loss aversion will make investors fear that we are one economic mishap or geopolitical event away from no growth or recession. Negativity bias will tend to exacerbate ‘spike’ reactions to event-driven geopolitical news, and the volatility bogeyman will appear more often.”
Furthermore, Moore suggests that the returns realised by investors will be “very disappointing” over the coming years, regardless how well markets do – as behavioural biases mean they buy and sell at the wrong times.
Explaining why investors have a “hard time” coping with volatility, he highlighting three cognitive biases: recency bias, or something suddenly seems to happen with improbable frequency just because it recently came to the forefront of investors’ attention; negativity bias, or a tendency to have greater recall of unpleasant memories than positive memories; and loss aversion, or dissatisfaction with losing money tending to be greater than satisfaction with making money.
Each of these can cause investors to react to market volatility in the wrong way. Moore uses the following graph, which shows how investors have sold out of funds in time of heightened volatility and therefore crystallised their losses, to illustrate this.
Investors often make poorly-timed investment decisions during periods of high market volatility
Source: Columbia Threadneedle Investments
The CIO added: “We need to focus on portfolio construction and an improved understanding of diversification. I accept that equities are likely to offer the highest return over the next 10 years, but they also offer the highest volatility.”
“Many portfolio construction optimisation tools use historical average volatility, which is likely to underestimate the volatility investors will face. The bogeyman emerges when individual asset class volatility spikes and cross-correlations rise, the combination of which increases overall portfolio volatility far beyond expectation.”
“Diversification is meant to protect investors against volatility, but what’s the point of owning lots of investments if the volatility bogeyman has not been properly estimated? The Sortino ratio, which differentiates spike volatility from general volatility, needs to be used more.”
The Sortino ratio was developed by Brian M. Rom from software development company Investment Technologies in 1983 and was named after Frank A. Sortino, who was an early populariser of downside risk optimisation. It is a modification of the Sharpe ratio and differentiates ‘bad’ volatility from general volatility by taking into account the standard deviation of negative asset returns, or downside deviation.
While the Sharpe ratio tends to be used for analysing investments that have low volatility, Sortino is better for putting more volatile portfolios under the microscope. A large Sortino ratio indicates a low risk.
For example, FE Analytics shows that the Investment Association fund with the highest Sortino ratio over the past decade has been TIME Investments’ Freehold Income, which is a portfolio of UK residential freehold interests ranging from single houses to blocks of flats. Over the past five years its annualised volatility has been 1.46 per cent while it has a maximum drawdown of zero.
The below graph shows how smooth the fund’s return profile has been over the last decade, compared with the FTSE All Share and MSCI AC World indices (these are not the portfolio’s benchmark).
Performance of fund vs indices over 10yrs
Source: FE Analytics
In a coming article, we’ll look at the more mainstream Investment Association sectors in greater detail to see which funds are performing best from a Sortino point of view.
Moore isn’t the only investor expecting volatility to ramp up in the future. Jane Davies, manager of the HSBC Global Strategy funds, is another warning that investors should continue to prepare for further periodic bouts of volatility.
“In a tough start to the year, equities and corporate bonds posted significant declines in January and February. This was driven by, first, fears of a manufacturing-led recession in the US, second by concerns over falling oil prices and, third, uncertainty over the outlook for China and policy agenda there,” she said.
“Overall, despite equity markets rallying back strongly from their February lows, the case for a modestly pro risk bias still makes sense; there is no recession and the prospective returns on safety assets, such as developed market government bonds, remain unattractive.”
