Paul Stewart: The risk of risk-adjusted returns?

*This article is brought to you by Grindrod Asset Management, a leading South African provider of income-based portfolios suitable for retirement.

By Paul Stewart*

As an investment house, we believe that the investment industry is often preoccupied with short-term risk and return. Delivering the best relative risk-adjusted returns has become an accepted means of comparing asset manager outcomes. Moreover, as asset managers and financial intermediaries have gradually become obsessed with volatility control, they have convinced their investors that they too should be concerned with volatility and downside risk, rather than delivering higher returns.

Paul Stewart is Head of Fund Management at Grindrod Asset Management.
Paul Stewart is Head of Fund Management at Grindrod Asset Management.

What are risk-adjusted returns? Simply put, how much bang (return) did I get for my buck (risk taken). In this case “risk taken” is not necessarily capital risk i.e. the risk of losing your money as the investor may assume.  Risk is rather defined as volatility, measured by the statistical concept of variance of returns. In other words, by how much did the portfolio value move up and down around its average (mean) return over a particular measurement period?

So the obvious question arises, is volatility an appropriate measure of risk for the long-term investor? Does the investor understand that capital risk and volatility risk are not the same thing? In our experience, the answer to both questions is a resounding no. In the context of risk and return, it is one of the incredible ironies of the investment industry that the legal disclosures in every piece of marketing material disclaim the fact that market prices may fluctuate. Yet short-term risk, as measured by volatility, is one of the key inputs used to sell products, measure outcomes and compare asset managers.

Market prices of tradable assets will fluctuate, at times wildly, from intrinsic value. This often occurs with little or no change in the fundamentals of the asset itself. In the long run, good quality companies that deliver sustainable financial results grow in value, even if they experience short-term setbacks from time to time. To be sure, it is not volatility avoidance but rather time in the market – measured in years – that matters to investors. When time in the market is combined with sensible investment decision making processes, the investor’s long-term outcome is rewarding.

William Bernstein in his 2013 book entitled Deep Risk: How History Informs Portfolio Design, correctly refers to volatility as “shallow risk”. Shallow because it is unpredictable, obvious and above all temporary. Why then do we insist on using this concept as the yardstick to measure portfolio risk?

The most profound risk for any investor, is the permanent destruction of their capital. William Bernstein refers to this as “deep risk”. Unseen and unexpected risks that have the potential to destroy value always lurk in the background. Natural disasters, wars, financial meltdowns and corporate failures are all capable of permanently destroying capital. Thankfully these occurrences are not very common.

According to Bernstein, the most common deep risks are inflation and deflation. We agree. For those of us living and retiring in South Africa, our structurally high inflation rate is enemy number one. Since inflation is generally cumulative, it slowly and silently kills your capital. Inflation is generally not sufficiently acknowledged for its truly destructive powers, in terms of real capital value and purchasing power. By the time one realises that inflation risk has decimated your portfolio, it is generally too late to respond adequately. If we know and understand the evils of inflation, why is this allowed to happen?

Given a risk preference, investors will almost always default towards avoiding short-term capital losses over avoiding long-term inflation losses. The behavioural explanation is simple. On an emotional level, most investors enjoy their gains and despise their losses. There is a resulting psychological asymmetry in how people view and adjudge financial risk. Short-term negative price fluctuations cause capital losses. These losses are experienced by investors on an emotional level as fear. They learn to avoid capital losses because of this emotional pain.

Conversely long-term losses in purchasing power due to inflation are incremental. They are spread out over years or decades in many cases. The emotional impact is therefore amortised rather than front-end loaded.  Of course when the investor finally reaches retirement undercapitalised, they are simply told, “You didn’t save enough”. This is an entirely avoidable outcome, but requires ongoing investor education.

Looking forward we see a world of low economic growth rates, high debt levels and declining social cohesion. It is entirely understandable that investors would want to avoid risk. Unfortunately due to high valuations and low current yields, forward looking expected returns are also less appealing in relation to historic return averages.

The message is simple. In order to achieve the after-inflation returns necessary to support many financial plans, investors have little choice. They need to invest in portfolios that hold higher long-term exposures to riskier (by shallow risk definition) asset classes like equity and real estate in order to trump inflation. Cash and government bonds will no longer do the heavy portfolio lifting. Be wary of risk-adjusted return promises.  Lower volatility generally means more cash.

Fortunately for skilled and nimble asset managers who understand this conundrum, there are still many opportunities for long-term investors to benefit from assets that are capable of delivering high inflation-beating returns by assuming some short-term volatility risk.

We believe this trade-off of taking additional short-term risk in exchange for enjoying long-term inflation-beating returns is the only sensible investment thesis. Some within the industry may disagree. Let the future be the judge.

  • Paul Stewart is Head of Fund Management at Grindrod Asset Management. You can email him [email protected]
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