By Jack Schwager
Volatility is often viewed as being synonymous with risk—a confusion that lies at the heart of the mismeasurement of risk. Volatility is only part of the risk picture—the part that can be easily quantified, which is no doubt why it is commonly used as a proxy for risk. A comprehensive risk assessment, however, must also consider and weigh hidden (or event) risks, especially since these risks may often be far more important.
The confusion between volatility and risk often leads investors to equate low-risk funds with low-volatility funds. The irony is that many low-volatility funds may actually be far riskier than high-volatility funds. The same strategies that are most exposed to event risk (e.g., short volatility, long credit) also tend to be profitable a large majority of the time. As long as an adverse event does not occur, these strategies can roll along with steadily rising NAVs and limited downside moves. They will exhibit low volatility (relative to return) and look like they are low risk. But the fact that an adverse event has not occurred during the track record does not imply that the risk is not there.
Consider, for example, Fund X that employs a strategy of selling out-of-the-money options. Barring abrupt, large moves, the fund will collect premium on options that expire worthless and will be profitable. The track record will be dominated by a large percentage of profitable months and relatively low volatility, providing an appearance of both consistent profitability and low volatility. But does this apparent volatility imply low risk? Not at all. Should the market witness a sudden, large price decline, the risk would explode, as formerly out-of-the-money options move in the money—a transition that is associated with a sharp increase the delta of the options (the percentage by which the option price changes in response to a price change in the underling market). Effectively, then, in this strategy, the greater the adverse price move, the larger the exposure becomes—the very antithesis of a low-risk strategy.
The behavior of investments vulnerable to event risk operates in two radically different states: the predominant phase when conditions are favorable and the sporadic phase when an adverse event occurs. It is folly to estimate overall performance characteristics based on just one of these phases. Assuming that low volatility implies that a fund is low risk is like assuming a Maine lake will never freeze based on daily temperature readings taken only during the summer.
Funds can be both low volatility and high risk. Funds that fall into both categories would have the following characteristics:
- They employ a strategy that has a high probability of moderate return and a small probability of large loss.
- Their track record overlaps a favorable market environment for the strategy.
- There were no major stress events for the fund’s strategy during its track record.
Our intention is to caution that low volatility does not necessarily imply low risk. There is, however, no intention to suggest that low volatility implies high risk. Of course, some low-volatility funds will also be low-risk funds. The key is determining the reason for the low volatility. If low volatility can be attributed to a strategy that assumes a trade-off of frequent moderate wins in exchange for the risk of occasional large losses (e.g., selling out-of-the-money options, leveraged long credit positions), then the risk evaluation must incorporate the implications of an adverse event, even if one did not occur during the fund’s track record. If, however, low volatility can be attributed to a strategy that employs rigorous risk-control—for example, a risk management discipline that limits losses to a maximum of .5% per trade—then low volatility may indeed reflect low risk.
Not only does volatility, as typically measured by the standard deviation, often dramatically understate risk in circumstances when hidden risks apply, in some cases, volatility can also significantly overstate risk. Some managers pursue a strategy that curtails the downside, but allows for large gains. Consider Fund Y in which the manager buys out-of-the-money options at times when a large price move is anticipated. The loss on these trades would be limited to the premium paid, but the gain would be open-ended. If, on balance, the manager was successful in timing these trades, the track record might reflect high volatility because of large gains. The risk, though, would be limited to the loss of the option premium. In effect, the manager’s track record would exhibit both high volatility and low risk
Fund Y is not the inverse of Fund X, which consistently sold-out-of the-money options. The opposite strategy of consistently buying out-of-the-money options might have limited monthly losses, but it would certainly be prone to large cumulative drawdowns over time because of the potential of many consecutive losing months. Also, since option sellers are effectively selling insurance (against price moves), it is reasonable to assume that they will earn some premium for taking on this risk. Over broad periods of time, consistent sellers of options are likely to earn some net profit (albeit at the expense of taking on large risk exposure), which implies an expected net negative return for buyers of options. In order for a long option strategy to be successful, as well as exhibit constrained drawdowns over time, the manager needs to have some skill in selecting the times when options should be brought (as opposed to being a consistent buyer of options).
So high volatility is neither a necessary nor a sufficient indicator of high risk. It is not a necessary indicator because frequently the track record volatility may be low, but the strategy is vulnerable to substantial event risks that did not occur during the life span of the record (that is, hidden risks). It is not a sufficient indicator because, in some cases, high volatility may be due to large gains, while losses are well controlled.
Jack Schwager is a recognized industry expert in futures and hedge funds and the author of a number of widely acclaimed financial books. He is currently the co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. Previously, Mr. Schwager was a partner in the Fortune Group, a London-based hedge fund advisory firm, which specialized in creating customized hedge fund portfolios for institutional clients. His prior experience includes 22 years as Director of Futures research for some of Wall Street's leading firms and 10 years as the co-principal of a CTA.
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