Rene Prinsloo, Portfolio Manager at M&G Investments
Investors are arguably as concerned, if not more so, with the risk-adjusted returns they are earning as they are about the level of absolute returns achieved. This is a good thing. Thinking in risk-adjusted terms allows investors to gain a better understanding of financial products, suited to their risk tolerance. However, this only works if the risk measure that you are relying on is telling you something sensible about how much risk you are taking.
The investment management industry has come to gravitate around volatility, or some variation thereof, as our risk measure of choice. For the most part this rule of thumb works well. But in instances where it fails, it can lead to bad investment decision-making.
Does return volatility = risk?
We would argue that volatility of returns should be a good proxy for risk, or investment uncertainty, within markets that are deep, liquid, and well-functioning. The volatility of South Africa’s equity market has historically tended to spike during periods of heightened economic uncertainty (see Graph 1). This rule of thumb also appears to work well on a bottom-up basis. If you were to compare the volatility of individual shares across a universe, you would tend to find companies in Consumer Staples, mature businesses and less leveraged names (operationally and/or financially), at the lower end of the spectrum. Resources shares and companies that are highly leveraged, should dominate the more volatile end. Arguably, the market does a fairly good job at distinguishing between companies with highly certain and more uncertain financial prospects.
This stands to reason. If we think about what the share price of a company represents, it is by definition the market’s expectation of its discounted future cashflows. If that share price is moving around a lot, this tells you that the market is uncertain about what the future holds for that company.
Beware the exceptions
This rule of thumb (volatility = risk), however, tends to break down in markets where market-depth and liquidity are less prevalent. An example is South Africa’s listed corporate debt market. It is much less reactive in periods of heightened uncertainty, as shown in Graph 2. For example, credit spreads, which indicate the risk of default of a corporate borrower compared to government risk, hardly budged during the COVID pandemic. The volatility of a typical SA credit portfolio would not, at the time, have signalled the prevailing market stress.
Our rule of thumb works no better for SA credit on a bottom-up basis. Had you, for example, been an investor in African Bank’s debt instruments just before the bank went into curatorship in August of 2014, you would not have been aware that anything was amiss by looking at how your portfolio was behaving. As Graph 3 illustrates, your bonds would still have been trading at par, with no volatility. By this point, ABIL equity and preference share investors would have lost substantial portions of their initial investments and would have seen the volatility of these instruments increase. Clearly, the volatility of your debt investments would have told you nothing about the amount of risk that you were exposed to at the time.
Additional Tier 1 (or AT1) bonds provide another interesting example of a divergence between volatility and risk. These are the most junior debt instruments that banks issue. AT1 bonds have some equity-like features such as the regulator’s ability to write them off completely, should the bank’s viability become questionable. These equity-like features were on full display in March 2023 for example, when investors holding US$17bn of Credit Suisse AT1 bonds were completely wiped out when the bank ran into difficulties and was acquired by UBS. Even though the regulator ruled that the bank’s AT1 bonds were to be written off completely, Credit Suisse’s shareholders still managed to walk away with $3.2bn. This experience demonstrates that AT1 investors should expect to suffer equity-like (or worse) losses from time to time when things go wrong.
Illiquidity distorts the risk picture
So why exactly does market volatility do such a good job at pointing out the risks in equity markets, but is no good at identifying credit-related risks? The short answer is that credit, in South Africa, hardly trades and most investors consider it to be a buy-and-hold investment, embedding less uncertainty into the instrument price, as would be the case for equities.
Investors should try to recognise situations where traditional risk measures are of little use. If a large portion of the assets that you, or your fund manager, holds, does not regularly change hands in the secondary market, even the most sophisticated risk model available is unlikely to tell you anything useful. . Beware of investment opportunities that give the impression of returns significantly in excess of the risk-free rate without accompanying additional volatility. Such situations do not arise naturally. If an issuer is paying you 300 basis points above JIBAR for lending it money, you are most certainly taking some investment risk, even if traditional risk metrics tell you otherwise.
ENDS
