Despite Brexit, US-China trade wars and Donald Trump’s tweets, actions from central banks across the world have meant that volatility in markets has been artificially supressed over the last seven years. 
For the seven years to 31 December 2019, the volatility of the MSCI World was 12.4 per cent, which is 3.6 percentage points lower than the 30-year average of 16.0 per cent.
However, Covid-19 has brought volatility in markets back and I suspect caught a number of newbie investors out. To put into perspective how choppy markets have been so far in 2020, for the last six months of 2019 the annualised volatility of the FTSE All Share was 10.1 per cent. However, for the first six months of 2020 it’s been a staggering 39.0 per cent.
The old adage of greater risk equates to greater return has also held true this year as, despite the MSCI World having a maximum drawdown of 24.6 per cent this year, it has bounced back strongly and the MSCI World in sterling terms was actually up by 1.7 per cent to 4 August 2020.
Source: FE fundinfo
What this year has highlighted is that the end investor rarely considers risk in terms of volatility but instead the actual loss of their capital. Therefore, when defining the risk of a fund, we should not just consider volatility but actually other metrics such as ‘maximum drawdown’ and ‘downside risk’.
Downside risk only considers a fund’s return which is below the determined risk-free rate. The best way to describe downside risk is the volatility of a fund in negative market conditions.
The reason this is important is because many investors place greater scrutiny on how funds perform during market downturns than they do in more normal market conditions. The best analogy would be a plane; do you care how smooth the journey is in normal weather conditions if all the bags fall out of the overhead luggage compartments during turbulence?
Over the seven years to 31 July 2020, there was one fund in the UK All Companies sector which was 48 percentile from a volatility perspective. Therefore, just looking at volatility you would assume that the fund would be middle of the road from a risk perspective.
However, over the same period its downside risk was 90th percentile and its maximum drawdown of 38.8 per cent was 80th percentile. Therefore going into 2020, investors may have thought that the fund would fall in line with its peers, however in reality it has fallen by a greater amount.
Maximum drawdown is defined as the difference between a fund’s highest price over a period and its lowest price over a period. To put it into context for the end investor, if they logged into their investment account when the fund was at its highest price and then the next time they logged in was when the fund was at its lowest price, would they be comfortable with the loss that they have experienced?
Investors do have to remember that the maximum drawdown of a fund is just two points in time. A fund may have lost 20 per cent from peak to trough, however it could have bounced back a week later and only be down by 10 per cent.
At Square Mile we also like to look at a fund’s time to recovery. This is the period it takes for a fund to recover from its maximum drawdown.
A fund may only have a maximum drawdown of 5 per cent, however an investor may be disappointed if its time to recovery is three years, as effectively their investment would have been in the red for three years.
As mentioned at the start, the MSCI World in sterling terms is up 1.7 per cent year to date. Anybody who had invested in the MSCI World at the start of the year and then went off grid for the rest of the year, may ask what the fuss in markets was all about.
Finally when looking at risk, making broad assumptions about asset classes can be misleading.
For example, assuming all funds in the same asset class have the same risk can lead to portfolios which are maybe taking too much or too little risk. Over the last seven years, the return from the highest risk fund in the IA UK All Companies sector (22.8 per cent) was nearly double that of the lowest risk fund (11.5 per cent).
Source: FE fundinfo; (red: lowest, blue highest)
This is the reason why Square Mile and FE fundinfo have added the risk of a fund within an asset class to the new Fund Dashboard. This should hopefully allow investors understand whether a fund is more or less risky than its peers and therefore avoid not taking enough risk by have a portfolio full of funds which are taking less risk than their peers or by taking too much risk as their portfolio is full of funds which are more riskier than their peers.
Tom Poulter is head of quantitative research at Square Mile Investment Consulting and Research. The views expressed above are his own and should not be taken as investment advice.