Investors need to be aware of volatility's limitations as an indicator of a fund’s risk, say investment professionals. 

The concept of risk has become more of an issue after a series of stock market setbacks have led to a lost decade for equity investors. 

Neil Veitch, manager at five crown-rated SVM UK Opportunities, says that this is leading to an industry obsession with a flawed metric. 

"The FSA is encouraging funds to have a volatility label and investors appear to be paying much more attention to volatility as a measure of risk," he explained. 

"While it’s understandable given the trauma we’ve seen in markets over the last three-to-five years, volatility in isolation is a relatively blunt measure. All volatility is – mathematically – is deviation from the mean."

The Committee of European Securities Regulators' (CESR) synthetic risk reward indicator is based solely on volatility but Veitch says that this can give an impression that defies fundamental analysis. 

"If we look over the last five or 10 years and took two global businesses, Apple and General Electric, Apple has been considerably more volatile relative to the index than General Electric yet investors would be much better off holding Apple. A broad-brush idea to take volatility as a measure of risk is misguided."

The 2008 financial crisis and the subsequent shortening of economic cycles have had a profound impact on market behaviour. According to Tim Cockerill, head of collectives research at Rowan Dartington, the behaviour of UK Government bonds proves that the investment landscape is subject to change and that means that attitudes to volatility must also evolve. 

"Gilts are risky in the sense that yields are low, returns are low and volatility is potentially higher than it has been on a historical basis. But on the other hand they are backed by the Government and we will be living in a very different world if they don’t reach maturity." 

Hargreaves Lansdown’s Richard Troue says that investors need also be wary of investments with low trading volumes or irregular pricing. 

"Property funds are subject to very big revisions because they are not priced daily like most mainstream investments," he said. "Past volatility might lead investors to get the wrong idea about a fund’s real level of risk." 

In the five years preceding 1 Jan 2007, the average IMA Property fund had an annualised volatility score of 5.27 per cent, roughly in line with the low-risk Global Bond or UK Index Linked Gilts sectors. 

However, in 2007 and 2008 the average property fund fell 14.6 and 30.12 per cent respectively. 

Performance of sectors 2007-2008

Source: FE Analytics

Cockerill says that investors shouldn’t confuse volatility with the notion of investment risk, but understanding the measure is, nonetheless, a central part of research. 

"A fund may have a three-year volatility number that suggests it is low risk but the asset class could be subject to external risks that aren’t being expressed by the historic data."

The main problem with a volatility score is that it is backward-facing and can’t contemplate wider factors.

While macroeconomic and stock-specific factors such as the eurozone debt crisis or the threat of a dividend downgrade are not expressed in the score, Cockerill says that doesn’t mean it should be discounted entirely. 

"Volatility isn’t necessarily the best measure of risk but it is a useful measure for telling you something about an investment as part of your overall research," he explained. 

"The way that we treat risk when we are meeting fund managers is to discuss the investment process and risk management mechanisms and then we try to categorise how we expect the fund to behave. Only then do we go and look at the volatility profile. If there are any surprises at that point then the volatility can tell us something that we didn’t know about the fund." 

"A fund with a high volatility score tells you that there is a real danger that when your time comes to sell there is a likelihood that you could be caught on the downside."