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Seed weekly - The risk is to the Downside

A previous article looked at why capital protection is an important factor when choosing a fund manager. Today we distinguish between good and bad volatility. In short, the volatility of the fund indicates how predictable the returns are. When a fund’s volatility is low, the monthly returns are very close to the average return over the period you are looking at (i.e. relatively predictable). The volatility of the fund is typically measured by standard deviation, how the much the monthly returns deviate from the average return. A money market fund will normally have low volatility. The opposite is true for equity funds whose volatility tends to be high, and the return predictability very low, in the short term.

The graph below shows the monthly returns of a money market fund compared to that of an equity fund over the past 5 years.

The graph above shows how stable money market returns are compared to an equity fund. The graph below shows the standard deviation of the funds.

But not all volatility is bad. Standard deviation takes into account up and downside volatility, but as investor you should be more concerned with downside volatility or loss standard deviation.

The graph below shows the monthly return distribution of 3 equity funds over the past 5 years.

Let’s first look at some statistics of the funds

Fund 1’s returns are the most concentrated compared to the other two funds. The fund does have a few months that are on the edges, but most months were between -2% and 2%. The fund also had the least number of negative months.

The returns for Fund 2 are slightly more spread out than Fund 1, but Fund 2’s returns are much more uniformly spread between -3% and 5%. The returns aren’t as concentrated as Fund 1. Fund 2 also has the highest average monthly return.

Fund 3 is the most spread out and also has the most negative months. The fund also had the lowest month return (-10.1%).

The graphs below plot the standard deviation (left) and loss standard deviation (right)

Because Fund 1’s returns are much more concentrated around the average return, its standard deviation is lower than the other two funds. Fund 2 and Funds 3 returns are almost equally spread out from the average monthly returns. That is why their standard deviation is similar, despite Fund 2 having more positive months than Fund 3.

This is why it is better to look at the loss standard deviation instead of only the normal standard deviation. On the right had side we can see that Fund 1 and Fund 2 loss standard deviation is very similar. The additional volatility of Fund 2, compared to Fund 1, is due to spread out of its positive months.

On the normal standard deviation and loss standard deviation, Fund 3 comes off the worst. The returns for the fund are most unpredictable and the chances of having a negative month are the highest.

Based solely on the quantitative information above we will tend to make use of Fund 2 in our solutions. While the fund’s returns may be more volatile than the other two funds, the volatility is mostly on the positive side. Naturally, in reality our process looks more in depth at both the quants and large emphasis is placed on the qualitative research before making use of any fund in our solutions.

Kind regards,

Gerbrandt Kruger

021 914 4966

Tue, 25 Nov 2014- 09:43

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