Volatility: Its Effect on Dollars versus Returns

When evaluating the performance of a manager, it is easy to get caught in the trap of judging them on their average annual return over a 3-, 5-, or 10-year period. It seems intuitive that we would want to hire the manager with the highest average annual return, right? It turns out, that is not always the best way to evaluate potential investments. We also need to consider the volatility of that return set.

Here’s a simple scenario:

Let’s say we are looking at two managers side by side and evaluating them on a multi-year basis. Manager A has an average annual return of 3% and Manager B has an average annual return of 4%. Which one would your client choose? Probably the 4%. The issue is that we haven’t been given enough information to properly assess how that return was achieved. Let’s say Manager A returns 3% every year and Manager B returns the stream you see below (and before you think it was cherry picked, these are actual S&P 500 returns for the years indicated below). You can see that Manager B has an average annual return of just over 4% over that time frame on paper making it appear to be the better-performing strategy.

However, if you use a dollar-weighted return calculation, which is more applicable when looking at actual dollars, you would find Manager A more appealing because they have delivered more dollars. Here’s the math:

Hypothetical Growth of $100

YearS&P 500 Index$ Return% Return$ Return
200613.62%$113.623%$103.00
20073.53%$117.633%$106.90
2008-38.49%$72.353%$109.27
200923.45%$89.323%$112.55
201012.78%$100.743%$115.93
20110%$100.743%$119.41
201213.41%$114.253%$122.99
Annual Return4% Avg. Annual Return$14.253% Avg. Annual Return$22.99

Source: Morningstar 2006-2012

A logical response to this scenario would be, “what investment can deliver exactly 3% per year?” Valid point… but what if you could find an investment that, over time, delivers 60% of the return in up years and only 40% in down years? Such is the aim of some long/short equity strategies. Here is how that would look:

Hypothetical Growth of $100

YearS&P 500 Index$ Return% Return$ Return60% Upside/
40% Downside
of S&P 500 Index
$ Return
200613.62%$113.623%$103.008.17%$108.17
20073.53%$117.633%$106.902.12%$110.46
2008-38.49%$72.353%$109.27-15.40%$93.46
200923.45%$89.323%$112.5514.07%$106.61
201012.78%$100.743%$115.937.67%$114.78
20110%$100.743%$119.410.00%$114.78
201213.41%$114.253%$122.998.05%$124.02
4% Avg. Annual Return$14.253% Avg. Annual Return$22.993.53%$24.02

Source: Morningstar 2006-2012

This hypothetical portfolio trails the market or a passive approach in five of seven years at an average of over 5%. This inevitably leads to frustration for your clients during those quarterly or annual reviews. However, that lag in the up years is more than paid for in the protection provided in negative years. But you only get that if you stay with it during the inevitable time periods of underperformance.

An advisor’s main goal when it comes to building portfolios for their clients is to find the proper risk/reward scenario. This same goal should be true when vetting individual managers. Managers that take a lot of risk or have higher volatility may have a better-looking annual return, but that isn’t always the whole story. Evaluating not only the standard deviation (and more importantly downside deviation – aka Sortino Ratio) but also the return for unit of risk (i.e., upside/downside ratio) is where you can get a robust return that really matters.

Read our recent blog post, The Disconnect between the Markets & Economy >