The Investment Risk Knowledge Gap

Posted by Peter Ellis, Director, P.K. Consulting Ltd. on Behalf of BISAM on Oct 13, 2015 10:13:36 AM
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The Investment Risk Knowledge GapMost of you reading this blog will have a pretty good understanding of investment performance. Even if you are not a performance analyst, you will probably know that a performance return is the difference between the values of an investment at different points in time, expressed as a percentage.

But what about investment risk? Excluding those of you who work in investment or performance teams, can you come up with a snappy description of investment risk that will be understood by everyone just like you could do for performance?

Performance and risk are two sides of the same coin: you can’t get a return on an investment without taking some risk. But I question whether the industry has done enough to communicate clearly with investors about risk.

For example, take a look at any fund factsheet. You will find information that is fairly easy to understand, such as historic performance returns and breakdowns of fund holdings by country and sector. And then you will find values for things like Information Ratio and Sharpe Ratio. But what does an Information Ratio of -0.1 mean, and what does a Sharpe Ratio of 0.35 mean? Are these good or bad, fantastic or disastrous? Most investors, upon receipt of their quarterly factsheet will work out that it’s a bad thing if their fund’s performance is lower than it was last quarter. But how many of them will know whether it’s a good or a bad thing if the Sharpe Ratio has increased over the quarter?

“Sharpe Ratio. That’s a risk measure isn’t it? And it’s increased this quarter. So that’s a bad thing, right?”

Understanding Investment Risk

We complicate the subject of investment risk and make it hard for many people to understand. For example, why do we use the terms ex-post risk and ex-ante risk? Why don’t we just talk about historic risk and future risk? And just what is the M2 statistic? (Unlike the R2 statistic which does actually involve the square of something, M2 is so named simply because it was first proposed by two people with the surname Modigliani.)

Asset management organizations must ensure that the risk profiles of investment vehicles are well aligned with the risk appetites of their clients, whether they be institutions or individuals. Depending on the risk appetite of the client, taking less risk than you said you would and delivering a lower than expected return could be just as bad as delivering a higher than expected return and taking more risk than you said you would. So clearly it is really important for investors to understand investment risk, and for asset management organizations to communicate clearly about it.

Demystifying Investment Risk

But if investment risk is really as important as investment performance, why is there is such a large gap in the level of understanding of these two sides of the same coin? It is time the industry made a greater effort to communicate more clearly about investment risk. And while I don’t have all the answers, kindly permit my attempt to demystify investment risk:

Ex-post risk measurement

This is the risk that was taken in order to achieve the performance return that has been delivered. So ex-post risk indicators are measures of actual risk. They can be grouped into several categories:

  • Variability indicators. These indicate the level of variability that has occurred in a set of performance returns. For example, the degree of variability in a fund’s historical returns.
  • Correlation indicators. These indicate how much the value of something such as the price of an asset or the performance of a fund goes up or down at the same time as the value of something else. For example, the performance of a fund compared to that of its benchmark.
  • Risk-reward indicators. These provide a combined indicator of performance and risk.

Each the above risk indicators is telling us something different about the risk that was taken to achieve the performance that was delivered. Variability tells us something about the risk of inconsistent performance; correlation tells us something about the risk that various factors could affect performance; and risk-reward indicators tell us something about how much performance was delivered per unit of risk taken.

Ex-ante risk analysis

This is the risk that will be taken to deliver a performance return in the future. So ex-ante risk indicators are estimates of potential risk. The fundamental approach behind ex-ante risk is to assess the extent to which the assets in a portfolio are exposed to future events, such as changes in interest rates, exchange rates, or economic downturns.

Predicting what’s going to happen in the future is a lot harder than explaining what’s happened in the past, so it’s not surprising that the techniques used in ex-ante risk analysis are more complex than those for ex-post risk measurement. Even so, it is still possible to explain it in simple terms.

And while the above categories of risk indicators apply for both ex-post and ex-ante risk, one additional category is important in ex ante risk: value indicators. These provide an indication of the amount of money that could be lost at some point in the future, which is clearly something that most investors would like to know.

Risk Isn’t Bad

The objective of risk control in our industry is not to minimize risk levels as it would be in most other industries, it is to ensure that the appropriate levels of risk are taken. Put another way, investment risk isn’t intrinsically a bad thing. But it is up to asset managers to communicate clearly and educate their clients about risk.

 

PS: the Sharpe Ratio is a risk-reward indicator, it shows the performance delivered per unit of risk taken. So an increase in the Sharpe Ratio isn’t necessarily a good or a bad thing. You got more performance for the amount of risk taken (good), but you may still be unhappy with the level of risk to which your investment was exposed (bad).


What do you think? Does the industry do an adequate job of demonstrating the risk they take against the performance they get? And do your investors understand the difference? 

As always, we encourage your frank feedback and points of view. Tell us what you think.

Topics: Risk Management

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