Going Greek and understanding investment risk
Editor’s note: This is a guest post from Ian Pascal, Marketing Director at Baring Asset Management.
“In this world, nothing”, said Benjamin Franklin, “can be said to be certain except death and taxes”.
Everything else is uncertain, and therefore involves an element of risk. However, risk means different things to different people.
From the individual investor’s perspective, it can refer to the extent to which your capital might be at risk if you make an investment, or alternatively it could mean the opportunity cost of you choosing one investment over another.
Fund management companies use a range of different and frequently obscure measures to show risk within each fund that they manage. At Barings, we believe it is down to us as product providers to explain technical terms clearly for financial advisers and investors.
We don’t always get this right but, with this in mind, I would like to go through some of the most widely quoted measures of risk you might come across when looking at the performance of individual investment funds, and try to de-mystify some terminology.
Alpha
One of the most commonly used terms, but probably one of the worst examples of jargon, is “alpha”, sometimes represented by the Greek letter “α”.
The term alpha comes from the hedge fund world, and simply means the degree to which a fund has outperformed or underperformed the benchmark it is trying to outperform. This is usually taken to be a very simple measure of the skill of the investment manager, although this is not necessarily the case. While a high alpha figure should be a positive sign, it should be treated with some caution. The fund manager may be taking a lot of risk to achieve such high returns.
Alpha can also be used in the sense that it describes the potential rewards available to a manager with skill in a particular market. Where a market is thought to be highly efficient, there may be less potential for investment managers to deliver “alpha”. The US equity market, for example, is a notoriously difficult one for active managers to beat.
Beta
In the same vein, “beta”, or the Greek letter “β”, is commonly used to show the portion of the fund return which is attributable to the market. For example, if a fund delivers 8% to investors, and the market has risen by 5%, then the alpha would be 3% and the beta could be said to be 5%.
“Beta” is also used in a second sense however, and that is how the volatility – or the pattern of performance – of the fund compares with the underlying market index.
If the returns from a fund twist and turn with the returns from the stock market, it would be said to have a beta of 1.0. It would be precisely as volatile as the market in which it invests.
If, on the other hand, the amplitude of returns was higher, and the fund tended to deliver stronger or weaker performance on a regular basis, the beta would be higher. Lower but more steady returns would mean a beta of less than one and the fund could be said to have relatively “defensive” characteristics, or at least when compared with the market it was investing in.
Tracking error
Tracking error is another term which gained currency in the 1980s and 1990s. This shows the “standard deviation” (yet more jargon I’m afraid for the non-mathematicians) of the returns between the fund and the market index over a particular period.
Standard deviation measures the degree to which returns tend to be clustered together around the average or the extent to which they are widely dispersed.
Tracking error is typically calculated to one standard deviation. This means that 67% of the time the difference between the return of the fund and the return of the benchmark index will be no greater than the tracking error.
Information ratio
Finally, another very commonly used measure of risk is the information ratio. This is an attempt to gauge the skill of the investment manager in a slightly more scientific way than simply looking at the alpha.
Calculating it isn’t difficult though. It simply involves taking the annualised relative return for the fund – the outperformance or the underperformance relative to the benchmark index – and dividing this by the tracking error.
The end figure shows how much “value” has been added by the investment manager for the risk taken. Looking at all of these various measures, the information ratio is probably the only one, where more is almost always better. All of the others simply help to provide more information about the way the fund is run.
If you are considering investing, and you discuss it with a financial adviser, you will soon see how hard they work to establish your individual attitude to risk. At the same time, it is reassuring to note that they are likely to have thoroughly researched and evaluated the individual risk metrics of a host of investment funds before recommending any products to you.
Ian Pascal is Marketing Director at Baring Asset Management in London. Ian is responsible for all marketing communications including promotion of mutual funds, alternative investments and private clients.
