Past Volatility is not a Guarantee of Future Volatility

A common statement investment managers must communicate to their clients and prospects and explicitly state in their marketing material is “past performance is not a guarantee of future results.” This disclosure statement is required to ensure that managers do not mislead investors into thinking that historical returns are indicative of what they can expect going forward. The investment community by now fully recognizes and accepts that past performance should not be the determining factor in choosing a money manager.

Relying on σ
Interestingly enough, it seems more and more apparent that the volatility of past returns has far more importance in the investment decision making process than many other variables. The standard deviation of returns is seen as a measure of risk. According to the prevalent thinking, a higher standard deviation of returns means that the manager is taking on added risk to achieve performance. As a result, investors prefer to invest with managers that have a lower standard deviation of returns because those investments are less “risky.”

In other words, the standard deviation (volatility) of returns appears to have become synonymous with the risk of an investment. But what exactly is risk? Standard deviation essentially measures the extent to which returns vary from the average of those returns. A lower standard deviation implies that returns do not deviate from the mean that much, while a higher standard deviation indicates the pattern of returns vary more from the average. Because standard deviation simply measures the “stability” of past returns, it is highly possible to have a low volatility investment that produces consistently negative returns. On the other hand, a higher standard deviation investment could produce year over year higher returns, adding value to an investment portfolio.

Predicting volatility based on the past
One could argue that it is possible for an investment to have consistently positive returns with a lower standard deviation. For example, arbitrage funds are known to have lower volatility than traditional investments, and can show a higher amount of consistent positive returns. The so called efficiency of those arbitrage funds in producing returns with lower standard deviations would result in many calling such funds low-risk investments, making them optimal investments for the risk-averse investor.

The problem is that standard deviation is based on past performance figures which may not necessarily have predictive power. If past performance is not a guarantee of future results, then how can past volatility, which is calculated from those past performance figures, be a guarantee of future volatility? One needs only to review recent history and be reminded of the rise and fall of hedge fund giant Long-Term Capital Management, which produced high returns with minimal standard deviation until the Russian default crisis of 1998. Investors believed in the concept of investing in a low volatility fund as a less risky proposition than other alternatives. However, Long-Term Capital Management’s past volatility prior to the Russian default was clearly not an indication of future volatility, let alone risk of losing one’s principal investment.

So what is risk?
This is a key concept that must be stressed. Risk is really the concept of how much one stands to lose from a particular investment. The ultimate risk is the complete loss of principal. Standard deviation does not calculate the probability of this going forward – it simply measures the past dispersion of returns from the mean. Because any investment may have the potential of losing all of one’s principal, comparing investments based on non-predictive standard deviation can result in sub-optimal investments.

The reality is that volatility itself changes. It is impossible to predict when an investment will exhibit a higher or lower standard deviation than the investment’s “average” deviation. The standard deviation of an investment based on ten year performance returns can be significantly different from its five year standard deviation. Which variable should be considered? Perhaps neither variable should be used as a determining factor because standard deviation 1) may not be a good measure of risk, and 2) is based on past performance which is not an indication of future returns.

Putting it All Together
Volatility is not necessarily a good measure of risk. An investor should not merely disregard a manager with high standard deviation, but rather evaluate that manager’s risk controls which help mitigate the inherent risk in any potential investment. Furthermore, the standard deviation of a manager cannot be accurately predicted. Using past volatility alone to screen through managers and eliminate those with higher standard deviations could result in the elimination of managers who, with hindsight several years later, would have been better to invest with, and had lower volatility. While volatility has taken on more and more importance especially after the 2000-2002 bear market, one should consider other factors rather than volatility alone in determining the investment merits and skills of a manager.

The views expressed in the foregoing commentary were prepared by AmeriCap Advisers, LLC based upon information available at the time such views were written. Changed or additional information could cause such views to change. We hold out no obligation to give readers of this commentary advanced notification of when we may change an opinion. The views expressed in the foregoing commentary should not be taken as advice to buy or sell securities. Information presented in this commentary was obtained from sources believed to be reliable, but accuracy, completeness and opinions based on this information are not guaranteed. None of the information in this commentary is intended as investment advice or securities recommendations for any individual or entity. The firm may, at any time, hold a trading position (long or short) in the shares of any company, whether or not discussed in this report. The firm may engage in securities transactions in a manner inconsistent with this report without notice. All data, information, and opinions expressed are subject to change without notice. Past performance is not a guarantee of future results. Neither diversification nor asset allocation ensures a profit or guarantees against loss. The report is offered for informational purposes only and is not intended to constitute either advice about appropriateness of obtaining advisory services or an offer to sell investment advisory services in any jurisdiction. Please see "Legal Notices".