The phrase ‘risk-adjusted returns’ appears frequently in literature and conversation related to investment strategies and products. Returns are (relatively) easily calculated and demonstrated, particularly looking back in time. The risk part of the phrase is more difficult to identify in relevant context, let alone to quantify. Consequently, is talking about risk-adjusted returns likely to be beneficial (to investors in particular) or is it an exercise in obfuscation?
The first stage, to my mind, in defining an investment strategy for most investors is to set a clear objective – how can success, or progress towards it, be assessed if it hasn’t been identified? The presence of an objective also helps with defining relevant, and related, risk metrics. For example:
- An investor aiming to outperform the FTSE 100 by 2% p.a. over 5 years might define risk as deviating from the index and consequently specify the related risk metric in terms of tracking error; or
- The trustees of a defined benefit pension fund aiming to be 100% funded might define risk in terms of a fall in the funding level and thus specify the related risk metric in terms of draw-down (of the funding level); etc.
There is no single ‘correct’ risk metric although I do think there is a most appropriate risk metric for each specified objective. The absence of a specified objective complicates matters.
Volatility is commonly employed as a risk metric, and is often used interchangeably with ‘risk’. Volatility might well be a relevant risk metric for a trader but how many savers, particularly those of the long-term variety, are actually traders? Even in cases where volatility is relevant, a mismatch between the trading horizon and the volatility calculation period might bring the relevance into question.
Key Investor Information Documents (“KIIDs”) do contain statements about risk and return although I question how helpful these statements actually are. Generally, the statements are quite bland and unhelpful, for example creating a range from “lower risk/potentially lower rewards” to “higher risk/potentially higher rewards” and then plotting the product in question somewhere along this range. This unhelpful starting point might then be taken a step further with statements along the lines of “this indicator is based on historical data and may not be a reliable indication of the future risk profile of the fund. The risk and reward category shown is not guaranteed to remain unchanged and may shift over time. The lowest category does not mean ‘risk free’. The value of your investment and any income from it can fall as well as rise and you are not certain of making profits; losses may be made”. My investments only expose me to the future performance from the point of investing so I don’t draw much from these KIID indicators.
The KIIDs provide a summary of the risk factors underlying the investment in question. A more comprehensive listing of the risks that the investment is exposed to is set out in the more detailed related documentation. The prospectus of the fund-range from which the preceding KIID quote was drawn sets out the following risk factors (I have removed country-specific risk factors for the sake of brevity): “accounting; active management; allocation of charges; basis; cancellation; cash flow; concentration; counterparty; credit; derivatives; dilution; discount; disinvestment; efficient portfolio management; emerging markets; equity investment; exchange rates; hedged share classes; high yield bonds; inflation; initial charges; interest rate; large flow disruption; legal and documentation; loss; market action; market closure; money market instrument; objectives; past performance; political expropriation; pricing and liquidity; prudency; redemption; remittance restrictions; securities lending; settlement and custody; short exposure; smaller companies; spread; suspension; tax; term; third party operational; uncertainty; and yield”.
This list of risk factors does undoubtedly feed into the overall risk that an investor is exposed to. However, the investor is looking to the fund manager to aggregate these factors into a limited number of relevant metrics (ideally one!) that the investor can understand in order to make an initial purchase decision. The relevant risk metric(s) also support the ongoing evaluation of whether the fund manager is delivering on the expectations created at the point of purchase. The investor pays a management fee in exchange for this aggregation service (and a bit more). The investor is not looking to evaluate each risk in isolation, and often has little inclination or capability to do so.
Quantifying risk, however it is defined, is necessary in order to calculate a risk-adjusted return. The quantification process, whether prospective or retrospective, might not be straightforward. I’ll pick-up some of these challenges in a future blog.
I am in favour of addressing the issue of risk, and the related discussion of risk-adjusted returns, but I question whether many of the current approaches facilitate a genuine conversation in this regard. It seems to me that much of the talk about risk is little more than lip service, lacking clarity as to the risk(s) in question and the relevance thereof to the investor. The challenge is to make conversations relevant and understandable. Perhaps longer and more specific exchanges are required in order to create deeper insights. Is there an appetite to invest the time and effort to have a worthwhile discussion?