Top Five Risk Statistics to Apply to
Your 2021 Portfolios
 

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by Ryan Nauman, Market Strategist, Zephyr

Despite uncertainties and obstacles investors faced in 2020, equity markets defied expectations and had a solid year, particularly since March 23rd lows. While markets disregard uncertainties on their way to new highs and investment portfolios made investors feel wealthier, it is important to remember that investment risk never goes away.
 
As we head into 2021, it’s a good time to revisit our top risk statistics that help advisors locate managers who optimize return per unit of risk and do a good job of preserving the hard earned gains since the pandemic drawdown. Below are five risk statistics we think financial advisors should consider when conducting manager due diligence in 2021.

1. Standard Deviation

Standard Deviation is one of the oldest risk metrics, which may turn away some practitioners. However, it remains applicable today. Simply put, standard deviation measures how closely returns track their long-term average. So, it measures volatility risk. Highly volatile investments are hard for some people to stomach, particularly those who have conservative risk tolerances. Furthermore, for those investors who are prone to taking the worst action at the worst time, highly volatile investments offer many opportunities to make mistakes.

Standard deviation should be a mainstay within your toolbox of risk metrics. However, depending on where your client is in his/her investment journey impacts what is a good number. A client with a short time horizon will prefer managers with low standard deviations so they can sleep better at night. Conversely, clients with a high-risk tolerance may not be as concerned with high standard deviation. In fact, (s)he may be willing to accept large negative swings for the greater potential for bigger rewards.

2. Sharpe Ratio

Sharpe ratio is the most famous return-versus-risk measurement, which represents the added value over the risk-free rate per unit of volatility risk. The Sharpe ratio addresses one of the obstacles financial advisors face when conducting manager due diligence and that is locating the most appropriate benchmark to compare your manager to. The Sharpe ratio simplifies the options facing the advisor by separating investments into one of two choices, the risk-free rate and anything else. It allows advisors to compare very different investments by the same criteria. Anything that is not the risk-free investment can be compared against any other. The Sharpe ratio allows for apples-to-oranges comparisons.

Regardless of where your client is in their investment journey, a large Sharpe ratio is welcomed. A high Sharpe ratio would imply significant outperformance versus the risk-free-rate and/or a low standard deviation.

3. Tracking Error

Tracking Error does a great job of measuring two return characteristics of a manager. First, tracking error measures how consistently a manager outperforms or underperforms the benchmark (excess return). It is created by taking the difference between the manager return and the benchmark return every month or quarter and then calculating how volatile the difference is (standard deviation of excess returns). Second, tracking error is useful in determining how “active” a manager’s strategy is. The lower the tracking error, the closer the manager follows the benchmark. The higher the tracking error, the more the manger deviates from the benchmark.  

Tracking Error helps investors determine if a manager makes big bets away from the benchmark and if those bets pay off or not. Again, it shows how “active” a manger’s strategy is. A client who is in the later stages of his or her investment journey may not want their managers to make big wagers, particularly if those wagers turn out to be on the wrong side. On the flip side, a client in the early stages of their journey may want a very active manager, particularly if those big wagers translate into larger outperformance compared to the benchmark.

4. Pain Index

Pain Index, which is a proprietary risk metric created by Zephyr, attempts to measure the complete scope of losses. It quantifies the capital preservation tendencies of a manager or index. Pain Index measures the depth, duration, and frequency of periods of losses. Furthermore, it addresses the shortcoming of only looking at the maximum drawdown and measures risk in terms of absolute returns.

During times of high volatility, like we experienced in 2020, it is important to reduce drawdown risk. Achieving investment goals is just as dependent on minimizing losses as maximizing gains. Pain Index is a very valuable metric that should be considered regardless of the client’s risk tolerance. A Pain Index of zero means an investment never lost value and represents the best possible outcome. The client would prefer, 1) smaller overall losses, 2) shorter periods of loss, and 3) infrequent losses. All three would translate into a lower Pain Index which is preferable.

5. Value-at-Risk

Value at Risk (VaR) is a tail risk metric that quantifies the amount of expected loss under rare-but-extreme market conditions. Markets experience losses, and occasionally those losses are extreme. Investors should be financially and mentally prepared to deal with the outcomes of these rare, but traumatic, events. VaR describes how much is typically lost in a day, month, or quarter when markets are at their worst.

VaR is a very insightful and important metric for clients who are concerned about capital preservation, with the biggest risk to achieving their investment goals is a deep market correction that they do not have time to recover from. The advisor and client can determine what level of occasional loss would be acceptable to bear. In this case, it is important to determine how a manager or index performs during these black swan or very rare market conditions and have they eclipsed the acceptable level determined by the client

After a strong, but tumultuous year for equities, it is important to reevaluate the risk statistics you use when conducting manager due diligence, particularly as investment portfolios reach all-time highs. As you evaluate your client’s progress towards their investment goals it is a good time to determine if you are using the appropriate risk statistic for each client’s investment journey.