C&B Notes

Confusing Volatility for Risk

A core tenet of our approach, one which we have written about regularly, is that risk is not a function of volatility, which can instead be an investor’s friend by providing opportunities to sell dearly and buy cheaply. This article is a nice illustration of how confusing volatility for risk can lead to poor outcomes for investors.

The confusion between volatility and risk often leads investors to equate low-risk funds with low-volatility funds.  The irony is that many low-volatility funds may actually be far riskier than high-volatility funds.  The same strategies that are most exposed to event risk (e.g., short volatility, long credit) also tend to be profitable a large majority of the time.  As long as an adverse event does not occur, these strategies can roll along with steadily rising NAVs and limited downside moves.  They will exhibit low volatility (relative to return) and look like they are low risk.  But the fact that an adverse event has not occurred during the track record does not imply that the risk is not there.

Consider, for example, Fund X that employs a strategy of selling out-of-the-money options.  Barring abrupt, large moves, the fund will collect premium on options that expire worthless and will be profitable.  The track record will be dominated by a large percentage of profitable months and relatively low volatility, providing an appearance of both consistent profitability and low volatility. But does this apparent volatility imply low risk.  Not at all.  Should the market witness a sudden, large price decline, the risk would explode, as formerly out-of-the-money options move in the money — a transition that is associated with a sharp increase the delta of the options (the percentage by which the option price changes in response to a price change in the underlying market).  Effectively, then, in this strategy, the greater the adverse price move, the larger the exposure becomes — the very antithesis of a low-risk strategy.

The behavior of investments vulnerable to event risk operates in two radically different states: the predominant phase when conditions are favorable and the sporadic phase when an adverse event occurs.  It is folly to estimate overall performance characteristics based on just one of these phases.  Assuming that low volatility implies that a fund is low risk is like assuming a Maine lake will never freeze based on daily temperature readings taken only during the summer.