Confusing volatility with risk can be “potentially ruinous” for investors, according to Barings’ Darryl Lucas, who said these terms have been conflated by mathematicians with no practical experience of managing money.
Lucas (pictured) runs the Barings Global Dividend Champions strategy, which aims to reduce downside in falling markets to prevent investors from panicking and selling out at the worst possible moment.
However, he said his portfolio is constructed in a different way to other strategies that claim to minimise risk, as most of these actually mean volatility, whereas he means capital loss.
“In fact, for the purposes of this strategy, we don't think of volatility and risk as being interchangeable at all,” the manager explained.
“They are absolutely not the same thing. It's a sleight of hand that the industry has done.
“It is interesting to observe over the last 15 or 20 years that as an industry we've just allowed mathematicians to tell us that volatility is risk, and there's been relatively little pushback from people actually running products that it might not be an appropriate measure.”
Volatility refers to how widely an instrument’s range of returns varies from its average over a particular period. Lucas said this means that if a company lost 10 per cent of its share price every day for 10 days, it would have just 30 per cent of its capital left at the end of this period. Yet its smooth downward trajectory would mean it had a volatility score over this period of zero.
“It's a zero-risk investment according to risk models, but you've lost most of your capital,” the manager continued.
“That sounds like a hypothetical example. But the problem is that mathematics gets worked into industry-standard risk models. I actually think that using volatility as a proxy for risk can be ruinous to investment returns if you're not being cognisant about what you're actually using.”
To illustrate this point, Lucas recently ran his portfolio through a standard portfolio modelling tool using volatility as the measure of risk. The tool recommended he sell out of some of the “resilient, predictable and growing companies” in his portfolio and replace them with banks from the Middle East, Japan and Canada, as well as a US mining company. The manager described it as something of a “struggle” to think this would minimise drawdown when times are tough.
“It shows that actually, those standard risk models prioritise theoretical diversification over minimising drawdown,” he added.
“They would prefer you own investments from a range of different sectors, regardless of the fundamentals of the business, to theoretically diversify, rather than owning 35 highly resilient companies which may all behave similarly.
“It's interesting that risk models mathematically push in that direction.”
Lucas said the way he thinks about risk is heavily influenced by his previous role as a credit analyst, meaning he focuses on the threats to the underlying business rather than fluctuations in the share price. He carries out stress tests on each company under a range of different scenarios, putting together a fan chart of how the business is likely to do under the best- and worst-case scenarios – and the narrower the range of distribution, the lower the risk.
The manager runs a concentrated portfolio, pointing out another flawed concept is that holding a higher number of companies automatically lowers risk.
“If you imagine running a 250-stock portfolio, there's no way that you can look at that portfolio and use your brain to think about where the risks are,” he explained.
“But if you have 35 stocks, you can identify the four companies that are growing strongly in Asia, the two companies somehow linked to US industrial production or three companies that are network-based business models that could potentially be disrupted by Amazon.
“More fundamentally, if you have a 35-stock portfolio you can seek to diversify those fundamental risks because it's a manageable set of companies.
“The expression I use is that you don't have to outsource thinking to a risk model.”
Data from FE Analytics shows Barings Global Dividend Champions has made 28.7 per cent since launch just over three years ago, compared with 32.12 per cent from its MSCI World benchmark and 27.47 per cent from its IA Global sector.
Performance of fund vs sector and index since launch
Source: FE Analytics
The $27.8m fund has ongoing charges of 0.85 per cent and is yielding 2.17 per cent.