Volatility – The Jagged Little Pill
Prepared by Paul Scully
Presented to the Institute of Actuaries of Australia
Financial Services Forum
26-27 August 2004
This paper has been prepared for the Institute of Actuaries of Australia’s (IAAust) Financial Services Forum 2004. The
IAAust Council wishes it to be understood that opinions put forward herein are not necessarily those of the IAAust and the
Council is not responsible for those opinions.
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VOLATILITY - THE JAGGED LITTLE PILL
This is a text version of an address to be given at the August 2004
Financial Services Forum of the Institute of Actuaries of Australia on the
theme of Coping with Volatility. The address is designed as a discussion
stimulant rather than a balanced consideration of issues and solutions.
The burst of (perceived) heightened volatility over the last couple of years has (again) raised
questions of how well the funds management industry anticipates and copes with volatility.
These questions have received greater voice in Australia than in previous times as compulsory
superannuation, the more populous shareholder base as a result of various privatisations and
demutualisations and the general increased interest in money matters, a Keating legacy, have put
our shortcomings on the financial front pages.
The defined contribution nature of compulsory superannuation translates negative returns into
individual member loss. The immediacy of this loss depends on the speed of the return
flowthrough in the crediting system employed by the fund. It is no surprise, then, that the funds
which appear to have the greatest smoothing capacity, the industry funds, appear to have been the
most successful in recent years.
This is unlikely to have been the only reason. Their greater use of alternative assets and the
dampening of volatility inherent in many of the valuations of these assets have assisted. (I will
leave the possibility of better general investment results for others to explore.)
The industry funds’ ready access to contributions cashflow also indicates a structural coping
advantage vis-a-vis other funds, akin to the automatic stabilisers cited by economists as budgets
go into natural deficit in the face of declining tax revenues in weakening economies. Even if not,
they create the opportunity to invest into a valuation up-curve, mean reversion permitting.
It is not only individual investors who are posing these questions. Australia’s big four banks all
made investments in wealth management as volatility was gathering pace. Lower asset values
have led to lower fee revenues and wealth management profits, and write-downs for those who
invested at premium valuations. Banking is a structurally and culturally different business to
wealth management and the recent experiences have caused analysts to at least question the
wisdom of the acquisitions made.
This brief paper attempts to bring a sense of perspective to the facts of our recent experiences, but
then extracts for discussion some of the issues raised in the comments that have been bandied
about in the industry and in the press. In reflecting on these issues, the paper raises questions on
the way some of our established practices act as coping mechanisms in periods of volatility. In
doing so, the paper looks at both the investment and business parts of funds management.
The public concern would not be stated as originating in volatility. The public concern is with
industry-wide negative returns. We can interpret this as deriving from the volatility of volatility
(heteroscedasticity) and, more particularly, the downside part of volatility. There is a potential
lack of perspective in disregarding the information provided by upside data points in volatility
and this is perhaps magnified by the representation bias (of behavioural finance) typified by
according the recent past more emphasis than other time periods.
This leads to the obvious question: Just how typical has the recent past been? For this purpose, I
will concentrate on equity returns.
Chart 1 – Australian Equity Return History Over 1900-2000
Source: E Dimson, P Marsh & M Staunton (2002), Triumph of the Optimists: 101 years of Global Investment Returns,
Princeton University Press, p232.
The authors note that the data on which the above chart is based was drawn from a number of
sources which have been blended to create a representative return history.
The (red) columns denote returns from Australian equities. Their spread about the zero return
line and the varying heights of the columns demonstrate the volatility of these returns. The ASX
All Ordinaries Accumulation Index returns for the years ended 31 December 2001, 2002 and
2003 were 10.13%, -8.10% and 15.86%.
The history of the standard volatility measure (standard deviation) is as follows:
Chart 2 – Australian Equity Volatility History Over 1979 to 2003
3 Year Standard Deviations
1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003
Source: ASX All Ordinaries Accumulation Index.
Standard deviations were calculated from monthly returns, and then annualised.
The corresponding chart for global equities is:
Chart 3 – Global Equity Volatility History Over 1979 to 2003
3 Year Standard Deviations
1980-1982 1983-1985 1986-1988 1989-1991 1992-1994 1995-1997 1998-2000 2001-2003
Source: MSCI All Countries Ex Australia (Total Return) Index.
Standard deviations were calculated from monthly returns, and then annualised. The relevant
MSCI Index returns for the years ended 31 December 2001, 2002 and 2003 were -9.65%,-27.13%
and -0.29% in AUD, and -14.21%, -24.01% and 25.8% in local currencies.
Given the mix of data sources and periods used in the above charts, it is not possible to be
conclusive on the trends disclosed by the above but there are indications which would find
sympathy in generally expressed views:
Equity volatility did increase over the first three years of the 2000 decade. The increase in
volatility featured some downside movement in returns.
The increase in volatility was greater for global equities than for Australian equities.
The increase in volatility followed a period of reduced volatility (part of the broader new
paradigm of the 1990s mentioned below?) The increase commenced earlier for global
The increase in volatility for Australian equities was relatively slight and left it a fair way
below its peaks over the last 25 years; the return gyrations of the last few years have multiple
precedents in the even longer term, though none since the early 1990s.
The increase in volatility for global equites was less forgiving in terms of it reverting to
As background, it may also be instructive to list episodes and events in the last twenty years that
might have caused return patterns to vary:
The stockmarket crash of 1987,
The recession of 1991,
The bond market crash of 1994,
The emerging markets crisis of 1998/9,
The tech crash of 2000 and, with it, the collapse of the new economic paradigm,
The return to value over the early 2000s, and
The rise in the $A of the last couple of years.
3. A 360o View
Risk, in particular, presents different aspects when viewed through the stakeholder prism.
Stakeholders occupy different positions along the risk transfer chain and the impacts of the risk
being realised also differ amongst stakeholders.
The illustration below identifies superannuation stakeholders. In this regard, I have used the
older term, trustee, instead of responsible entity to express more directly the nature of the
obligation owed to the member by this office bearer.
For a more general fund, the bottom half of the illustration would be more relevant.
Chart 4 – Superannuation Stakeholders
Moving beyond risk, the industry’s performance reporting conventions can be characterised in
some ways as taking a manager centric view. Time weighted returns before tax may have strong
technical justification but returns in investors’ hands are received money weighted and after tax.
How many managers even look at such returns on a per customer basis as a regular part of their
customer service programs? Without doing so, do we have real insight into their return
4. Issues of Discussion
Comments made on the industry’s performance in generating returns in the recent past have taken
in both asset allocation and asset class performance. The asset class in the cross-hairs has been
4.1 Asset Allocation
As we know, asset allocation operates both strategically and tactically. Strategic asset allocation
(SAA) defines the combination of assets that best matches the long term risk/return preferences
of the underlying fund/investor. Tactical asset allocation defines (TAA) the ranges around which
the manger is free to move as markets vary over time. In other words, TAA allows coping room
as volatility changes. That returns have been negative begs the question: has this room been used
to best effect?
Taking this to an operational level:
TAA usually operates on an incremental basis. Does this provide sufficient challenge to the
views underlying the current asset allocation? Does it mean that the wider ends of the ranges
are under-utilised? If so, do managers deny themselves and their customers an available
opportunity to cope with changing circumstances?
The standard CAPM and similar models require inputs of returns, volatilities and
correlations. The general practice for volatilities is to use results over the most recent 3 or 5
years. This has an implied logical flaw if return forecasts are made independently of the
volatility estimates. Does this mean that we will necessarily miss changes in volatility?
While there is a general (and understandable) reluctance to forecast volatilities, perhaps
reverse optimisation techniques might be used to infer the volatilities implied by the current
or proposed asset allocation and these could then be tested against the expected environment.
Have we lost sight of cyclicality as a phenomenon and a conscious input?
There is a school of thought that disputes the consistent value adding potential of TAA. Has the
recent experience made adherents of this view think again?
Presumably implied in the rebalancing-preference of the anti-TAA adherents is a belief in and
requirement for mean reversion at some level. A waywardness in volatility will alter the
reversion path and speed concomitant to this belief. Does this imply anything for the horizon
matching (personal vs fund) that investors undertake prior to investing and in maintaining their
The general consensus is that currency is a zero returning asset over the long term. This view is
then premised into suggesting the extremes of full and nil hedging of foreign equity exposures as
the natural positions to take. Full hedging is proposed when there is a high liability sensitivity, so
that the local currency value of liability outflows can be protected within the comforting
expectation of no detriment to long term returns (save for hedging costs); and nil hedging when
there is no such sensitivity.
For a balanced fund, an additional consideration is the effect of hedging on total returns. Nil or
lesser degrees of hedging will generate some correlation benefits that will reduce risk. The level
of exposure to foreign equities provides a scaling tool against which the practical value of these
benefits can be assessed.
Tactical hedging is practised in some places but the apparent randomness in short term currency
movements has led others to question its justification. There is some evidence of trending in
Whatever the view taken, it is indisputable that hedging was a crucial decision point in 2003. The
unwinding of the under-valuation of the AUD relative to the USD (exemplified by the difference
in cash rates) made this so.
4.3 Investment & Profit Horizons
A standard consultant and manager response is to point investors to the longer term as a means of
assuring them that they will be rewarded eventually as markets swing back in their favour.
But tough times shorten horizons and we have been informed by behavioural finance and our own
experience that risk profiles can change when returns turn negative. However misadvised
investment professionals may feel this is, we need to appreciate that investors have their own net
wealth on the line; and trustees feel responsible for investment outcomes in a non-choice
At the very least this change in outlook can create problems in communicating with investors. It
may also call into question the assumptions on which the original investment recommendation
As mentioned in the introduction, investors are not the only players to have split-horizon
The corporate side of the investment world is as much slave to the budget and profit
announcement cycle as other companies. This cycle is usually characterised by:
A 1 year time frame,
An upwards sloping (almost straight line) budget profit gradient,
Monthly or quarterly internal reporting, and
Regular reforecasting of expected annual profit.
While allowances can be and are made, this framework by its nature assumes a high degree
revenue continuity and/or expense flexibility, and is generally ill suited to volatile markets. When
markets and returns head south, revenue usually goes with it, leaving expenses as the most
available means of keeping profits on target. People costs usually account for 60%+ of total costs
in funds management.
The sell side of the investment world seems to have developed a rapid up- and down-leveraging
system of dealing with revenue volatility. This involves a large amount of periodic hiring and
firing. The staffing turbulence that this implies would not be acceptable to asset consultants, so
does this preclude such an approach for funds management? If yes, then what explains the
regular bouts of staff turnover that take place?
What are other ways that the expense line can be managed?
Changing the mix of fixed and variable pay? Bonuses and other incentives presumably reduce in
value if results fall short of expectations. But they also then lose their retention power (assuming
some element of deferral in their design).
Delaying system and other expenditures will save outlays in the short term but will also delay
efficiencies, suggesting that such a response might actually cost money in the longer term.
(Incidentally, equity analysts often impose a similarly narrow earnings announcement framework
on listed companies.)
4.4 The Good Old Days
In the good old days smoothing mechanisms or book based valuation measures were often
available as means to shield investors (and managers and consultants?) from the immediacy of
short term falls in value. In these days of yore, superannuation was predominantly defined benefit
in nature and the sponsor/employer bore the cost of volatility. Those days have largely
disappeared for most of us and any vestiges are being expunged by the relentless drive of the new
international accounting standards.
It is still possible for defined contribution funds to smooth returns, and many industry funds
apparently do so. (The extent is difficult to measure as there is not much public disclosure on this
issue.) Most commercially run funds don’t do so largely because they don’t have the same ready
access to membership stability and its associated cashflow to accommodate equity and like
Smoothing prevents the comparison of like-with-like performance across funds, so it is not really
possible to verify the assertions of better investment performance by industry funds. The citation
of smoothed returns in surveys is justified by such returns being those received by members. But
the disclosure of the underlying investment performance would not preclude the use of smoothed
returns for member accounts. It would also improve transparency.
Used well, smoothing can allow the release of news in a manner consistent with a long horizon
perspective but it is not really a means of directly coping with volatility. While the surface
perceptions are better, the “underground” effects are the same. If things turn around as expected,
it provides a short term safety valve; it can be dangerous, though, if things don’t turn around as it
may force more severe actions later on.
Cashflow reliability allows more flexibility in asset allocation by allowing the deployment of new
cashflow in a different mix to current assets. For this to be practical, a single constituency base
like an industry fund would be desirable. Clearly, the greater the proportion new cashflows bear
to current assets, the more the flexibility that is obtained.
4.5 Trueness to Label
Trueness to label is now an article of funds management faith. Beyond the compliance
implications of respecting risk and other such limits, investors are entitled to get what they paid
for. But what if, in the process of weathering the volatility storm around us, we come to realise
that some of the limits we have put around the investment process are constraining our ability to
respond as well we might?
In the consultant- and advisor-mediated world that is now funds management, are the
communication lines too long to allow for the flexibility that a more direct relationship might
4.6 Indices as Asset Class Benchmarks
Indices came to prominence as threshold measures for active management. To justify an active
management fee, the manager had to outperform the index by at least the active less index fee
margin. For equities, this is in the region of 40-50 basis points.
Indices also became risk proxies with the rise of tracking error.
This concept of risk was transferred from the investment arena to the business arena.
Underperformance relative to the index would be punished by the loss of mandates; hence taking
an active position is to incur business risk. Growing funds under management can magnify this
concern as greater amounts of revenue become vulnerable and size reduces nimbleness.
What happens, though, when index returns are negative as in recent years?
It is no accident that hedge funds and other absolute return products are being promoted
aggressively. The times have suited the pitch of focusing on positive returns whatever may
happen to the index. But such products have their own risks as standalone vehicles and these
risks may be greater than index sensitive risk – e.g. leveraging; exposure asymmetry through
shorting; underperformance when indices rise; lack of transparency and a proven full cycle
Paradoxically, though, hedge funds are also attracting risk management attention. If they can
really provide some form of index insensitive performance, they promise extra diversification.
Many hedge funds appear to see volatility as an asset. This is particularly so of arbitrage-based
strategies or processes. There are also volatility based strategies in the world of options. Maybe
this is the investment equivalent of making a virtue out of necessity, a time honoured coping
4.7 A Broader, Risk Graduated Product Range
For a manager with growing funds under management in its core products, one way of coping
with the threat of new products that appear to offer something tantalisingly different is to join the
throng. This can be done in a number of ways – starting with a blank sheet of staff paper and
hiring in specialists in the new product class; loosening up the controls on the core product to
provide versions along the risk spectrum that more effectively compete with the new products; or
creating relationships with product providers to offer their products to the manager’s customers.
From a customer perspective, this adds to an already overcrowded product menu. Customers
may also question whether the manager has the skills to offer competing products simultaneously.
From a manager perspective, sooner or later the economics of such new products and a broader
range will have to prove themselves; and this may come sooner if revenue is already sagging,
adding to the expense management quandary cited earlier.
4.8 The Rise of Boutiques
The boutique phenomenon has been extensively reported. While boutiques are present in most
sectors, they are heavily concentrated in equities and hedge funds, the most “volatile” of asset
A range of reasons have been advanced in explaining the rise of boutiques:
The growing appreciation of size as a performance limiting factor in equities,
The desire for genuine equity in the business by investment professionals,
Successful investment managers opting out of institutions into a world in which they can
control their own destinies and spend more time on what really interests them,
Greater flexibility in getting new ideas accepted and products into the marketplace, hedge
funds being a leading example,
A refuge for victims of industry consolidation,
A shift to distribution away from manufacturing in the institutions under the new separation
The creation of a supportive plug-and-play infrastructure in the forms of fund platforms,
Boutiques are an interesting structural juxtaposition in a scale-obsessed and consolidation-
focussed industry (although size is more often gained than genuine scale). Maybe there is
something more fundamental or secular at work – boutiques as an internet style model of
investment management manufacturing; all you need is a home page/shingle on the front door?
Whatever the reasons might be, the volatility of recent times has strengthened the currency of
boutiques and highlighted the problems institutions have in times of rapid change. Not
surprisingly, some boardrooms are canvassing the possibility of creating internal boutiques along
the holding company lines of the Treasury Group in Australia or the earlier United Asset
Management and other entities in the United States.
5. An Aside on Coping
Given the incursion of psychology into investment management in the form of behavioural
finance, I thought it might be interesting to see what psychology has to say on coping, the theme
of this address.
What follows is essentially drawn from one source, a paper, Coping Strategies, published in 1999
on the internet by J D and C T Macarthur of the Research Network on Socio-Economic Status and
Health, an American group. It in turn summarises the work of its Psychological Working Group
Coping strategies are employed to “master, tolerate, reduce or minimise stressful events”. There
are two broad families of strategies – problem-solving strategies and emotion-focused strategies.
Problem-solving strategies seek to do something active to alleviate the effects of stressful events
and are more typically used for stresses that are regarded as controllable; whereas emotion-
focused strategies seek to “regulate the emotional consequences” of stressful events that cannot
be controlled but must be endured.
The other distinction made is between active and “avoidant” coping strategies. Active strategies
are “designed to change the nature of the stressor itself”, while avoidant strategies allow the
individual to avoid directly addressing the stressful events. Active strategies are thought to be
better strategies because avoidant strategies carry risks such as withdrawal or alcoholism and may
leave the individual open to future stresses of the same kind.
People will typically use of a combination of strategies, with the predominance of one or another
depending on personal style and the nature of the event faced.
These general distinctions are of limited utility in assessing their effectiveness, something that
appears to require more specific information. A range of measurement tools has been developed
for this purpose. Two tools quoted are set below along with the secondary characterisation of
Ways of Coping COPE
Confrontative Coping Active Coping
Seeking Social Support Planning
Planful Problem-Solving Seeking Instrumental Social Support
Self-Control Seeking Emotional Social Support
Distancing Suppression of Competing Activities
Positive Appraisal Religion
Accepting Responsibility Positive Reinterpretation & Growth
Escape/Avoidance Restraint Coping
Resignation & Accepting
Focus on & Venting of Emotions
It would be interesting to interpret the discussion in Section 4 above in the context of these
coping strategies. I will leave the reader to the privacy of their own nightmares to do this.