Returns are not Enough Paul Roberts proberts@arlingclose.com

Financial markets can be volatile at the best of times, but in the midst of the global pandemic, well, we will all be familiar with what happened earlier this year when equity markets plunged, pushing down the values of many pooled funds. Correlations between asset classes, which should in ‘normal’ times help diversify investment portfolios, can break down in times of severe market stress as panic causes asset class returns move in the same direction, reducing diversification.

Although equity markets have regained some ground (or in some cases broken new ground), the events of this year have highlighted just how volatile financial markets can be and how uncomfortable the knock-on impact on pooled funds, and indeed most investments, sometimes are for those with skin in the game, be it their own money or someone else’s.

As clients will know, we are big fans of pooled funds. In a world of purchasing-power-eroding cash investments they offer the potential for inflation-beating gains in capital values and, more importantly for some investors, decent levels of income which in the case of local authorities can actually make a major contribution towards achieving of annual budgets and the delivery of services.

Our clients will be aware of our recommended time horizons for investing in pooled funds, and their performance should be reviewed regularly to ensure they are still meeting any desired or essential return objectives. While the returns of each fund are relatively straightforward to measure, together with individual fund volatility, for a more complete picture of what is going on at the portfolio level we need to dig a bit deeper.

Risk attribution can help to identify the sources of volatility within the portfolio, be it at the level of each asset class, each fund, or even investment factor (e.g. size or style). When analysing performance at the portfolio level, both the level of return and overall risk (measured by standard deviation) may appear satisfactory, however, if for instance the portfolio comprises a number of pooled funds, a more detailed analysis would highlight each fund’s marginal contribution to the total risk of the portfolio.

Marginal contribution to risk uses the correlation between the funds to enable the investor to determine how much volatility each asset class or fund etc is adding to the portfolio. While risk (not just from price volatility) is inherent in any investment, investors typically want to be rewarded with a higher return for taking a higher level of risk. Measuring the fund’s marginal contribution to risk will enable the investor to do just that.

This analysis can help the investor in their portfolio review and decision-making process, particularly when looking at a potential portfolio balancing or change in funds or asset allocation. If a fund is adding a high degree of volatility to the portfolio but comes with a commensurately high return, then fine, assuming the investor’s risk tolerance or portfolio objectives have not changed. However, if the portfolio’s volatility is being driven by a single fund or small number of funds which aren’t providing a sufficiently high return in compensation for this it may be time to reassess the portfolio, either to potentially reduce risk for the same level of return or to increase the return for the same level of risk.

Rather than just helping to identify high levels of risk, the analysis would also highlight funds which may only providing a relatively modest return but are doing so with an extremely low degree of volatility. Such funds may therefore be doing the bulk of the work reducing portfolio risk and bringing real diversification benefits, providing a solid foundation for the other funds.

After detailed analysis of the portfolio, any changes to its composition should only be made after careful consideration and planning, and while investors tend to focus primarily purely on returns when deciding whether or not to retain an investment, for a fuller picture risk should also be involved in any decision-making.