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Alpha is a measure of the amount of performance return which cannot be explained by market movement. In other words, it is the value added by the Fund manager over and above what should have been achieved by an unlevered investment in the underlying market in which the Fund operates. We want the Fund’s Alpha to be as high as possible, all other things being equal. It is possible for a Fund to exhibit a high positive Alpha over short time periods which may have been generated by luck, but over longer time periods (say five to ten years) it is statistically more probable that a Fund manager has generated Alpha through skill. We therefore ascribe more weight to funds with a longer track record of generating Alpha.
Volatility is a statistical measure of a fund’s price movement over time. It is calculated mathematically as the fund’s annualised standard deviation from its mean return. We can use the Fund’s volatility to estimate the likely range of returns in a given period. According to modern portfolio theory, 68% of returns will be within one standard deviation and 95% of returns will be within two standard deviations of the mean expected return. For example, a Fund with an expected return of 8% and a standard deviation of 10% has a 68% probability of producing a return between -2% and 18% and a 95% probability of a return between -12% and 28%.
Higher return usually implies higher volatility. We try to limit the level of volatility since large swings in the value of a portfolio can have several undesirable consequences for investors:
It is more challenging emotionally to adhere to a strategy if your portfolio has large negative changes in value, even if these are frequently followed by large increases.
Higher volatility leads to an increased dispersion in the possible terminal values of a retirement pot making it more difficult to plan a retirement date.
Making withdrawals from a volatile portfolio when the value has recently declined has a larger permanent impact on the potential for the portfolio to recover.
We also look for movements in a Fund’s historical levels of volatility as this can indicate changes in strategy.
The Sharpe ratio is a measure of risk-adjusted performance. It is calculated by taking the return of the fund, subtracting the risk-free rate, usually a short-term Government bond yield, and dividing the result by the standard deviation of the fund’s returns. The global investible universe has been estimated to have a Sharpe of 0.28, which means that an investor receives 0.28% of additional return for each 1% of additional volatility. When comparing Funds with similar returns, the fund with the higher Sharpe ratio has achieved those returns with less risk.
We do not believe there is a need to take complexity risk. History has shown that adding complexity to financial products enables the product distributor to pocket large fees, often leads to conflicts of interest between seller and buyer and regularly results in substantial losses. Unless the risk/reward potential is exceptional we do not invest in such products.
Funds which appear in the top third of their peer group over medium to long term horizons are preferred over Funds which have a spectacular short term record but are unproven or have a disappointing record over the long term.
Beta measures the tendency of a fund’s returns to respond to market movements. A Beta of less than 1.0 implies that the Fund will be less volatile than the market. All else being equal, we like funds which have a low Beta and high return as this usually implies the manager is adding real value.
Correlation measures how two assets move in relation to each other. A perfect correlation means the assets move in lockstep and the correlation is +1.0. Perfect negative correlation means the assets move in opposite directions and the correlation is -1.0. We like Funds which have a low correlation to one another and a low correlation to the market.
Why is correlation important? Increasing global market integration has led to increasing correlations between equity markets. Diversifying the portfolio with assets where the risks and returns are not associated with equities or bonds will improve the risk/return relationship of the portfolio. Such assets include real estate and commodities, specialised investment strategies such as global macro, market neutral and long/short hedge funds, and investments which combine such features, for example private equity and distressed debt Funds.
If two Funds have a low correlation with each other, the average of the two assets will have lower volatility than either asset individually for the same average return. In other words, adding an asset with a similar expected return but low correlation to a portfolio can result in a reduction in the portfolio’s volatility without affecting the overall return. Correlations also increase during times of market stress causing contagion, increasing the importance for seeking alpha which is uncorrelated to any market or industry, as a major component of total return. Contagion can be thought of as excess correlation – correlation over and above what one would expect from economic fundamentals. We spend a lot of time seeking risk-diversifying alpha-producing funds.
The FE Risk Score is a measure of volatility relative to the FTSE-100 which has a risk score of 100. The lower the risk score, the less volatile the Fund is judged to be.
Significant losses to a portfolio’s value can cause anxiety and make it difficult to adhere to an investment strategy. We look for Funds which have managed to successfully navigate through periods of market turmoil such as the periods August 2000 to March 2003 and October 2007 to March 2009 when the FTSE All Share fell by over 40%.