Volatility helps the long term investor

by Rob Davies, Fund Manager

One reason investors dislike equities as an investment vehicle is the volatility that accompanies them. Most people can remember the crash of 2008 when markets fell 50%, many will recall the plunge of 2001 in the wake of the dot come bubble bursting and then 9/11. There are even a few old lags who lived through the 1987 storm.

These dramatic swings in valuations unsettle savers. It makes them doubt the security of their investments and pushes them instead to the apparent safety of cash and fixed income. The downside of that of course is that, over the long term, these asset classes do not offer such high returns as equities.

Volatility is the price equity investors pay to get better returns. It goes with the territory and it is a price worth paying for those able to take a long term view and tuck capital away.

Right now volatility is low. Not just in terms of months, or even years, but in decades. The most well known measure of volatility is the VIX index on the Chicago Options Exchange. Its current level of 10.5 is the lowest since the mid-nineties and is in stark contrast to the levels of 30 or 40 experienced a few years ago let alone the peak of nearly 90 attained in 2008.

This low level of volatility may well tempt some new investors into the equity market and that would be a good thing. However, they are misguided if they think this stability will continue. It won’t be. Something will happen to destabilise the current equilibrium and markets will oscillate, possibly dramatically so.

In fact it is surprising that markets have been so stable in the face of tensions in the Ukraine, the China Sea and the lacklustre performance of so many Western economies. One reason for this can be summed up in the old saw that says “Don’t fight the Fed”. Ever since the global financial crisis burst the US Federal Reserve has been creating conditions to ameliorate the worst effects of the drama. It has been joined in that task by the Bank of England, the European Central Bank, the Bank of Japan and the People’s Bank of China. With so many entities willing economies to do better, and facilitating it by printing money on an hitherto unimagined scale, it is perhaps not surprising that equity markets have made upward progress, and in a remarkably smooth manner.

Some distortions have occurred, perhaps most notably in London property, but overall conditions seem remarkably benign. It won’t last of course. Eventually some event will occur that will overwhelm the central banks, or take them by surprise. When it does volatility will return to markets, and probably with a vengeance.

That will be when investors suddenly start taking an interest in two measures that rarely attract a lot of attention when selecting funds. One is standard deviation and the other is maximum drawdown. The first simply measures how a series of monthly returns over a given period vary around the average monthly performance. The lower the score the smoother its returns are month in, month out. It is an indication of how good the suspension is at smoothing out the bumps.

The other measure shows the largest decline in the net asset value (NAV) of a fund from its peak to trough. This can be measured over different timeframes. In effect, it quantifies the biggest cumulative loss an investor could have made by entering and exiting the investment at the worst possible time in that particular period. Another way of thinking about it is as an indication of how much support the stocks in a fund might have from fundamental measures like yield and price earnings ratios. If a fund is full of racy growth companies it is likely to fall further than one that has a bias to boring shares that offer good yields.

No one knows when volatility will return to the market. But it will. And, like any house owner, the time to prepare for bad weather is when the sun is shining so the time to buy low volatility funds is when volatility is low.