Back tracking: Looking back to go forward

Investors in international equities are well aware of the tremendous fall in volatility in equity markets over the last few years. The drop in volatility has been both in absolute terms and also relative to benchmark indices. Many investors are looking at the drop in volatility and are fearful that investment portfolios do not contain the level of risk that they are paying for.

There also is a perception that the relatively high fees demanded by global investment managers will detract a large portion of the excess returns generated in this environment. The source of this perception is that tracking error is used as an indicator of portfolio potential. However, using tracking error in this way can be problematic.

Tracking error of the average investment manager has dropped markedly over the past few years. The InTech survey of International Equity managers shows the median manager tracking error now a little over 1 per cent versus the recent high in 2000 of over 2.5 per cent. Over the same period, market volatility has fallen dramatically and is now around historical lows.

“It’s often said that we walk backwards into the future and in an investment sense this can be disastrous,” says Suncorp Investments head of world equities, Rob Wood. “It can mean buying what has already out-performed and selling what has under-performed. In a risk sense, it can mean increasing the risk profile at an inappropriate time.”

In fact, there has been a notable response by some funds to the contraction in market volatility toward raising the risk profile in search of returns or, alternatively, switching to an index fund in pursuit of a better value for money proposition.

Tracking error calculations rely on historical price moves, and therefore it is not surprising that ex-post and ex-ante tracking error numbers are very similar. But ex-ante tracking error estimates and the subsequent realised actuals can differ by a wide margin. Put another way, ex-ante tracking error is but a soft signal of future excess return ranges of a portfolio. When volatility is rising, forecast tracking error will undershoot actual and vice versa.

It is also evident that tracking error and overall market volatility can change significantly over a very short period of time; often too short a time to allow an investment response. When the tech bubble burst, tracking error for the top quartile manager shot from 2 per cent to 4 per cent in a matter of months.

Despite this, volatility is what makes markets. For stock picking equity managers, volatility is their lifeblood but most treat the concept of tracking error with extreme caution when it comes to providing insight into the return potential of their portfolios.

Wellington Management’s Kim Williams said they prefer to look at the spread of returns within the market sectors to gauge the opportunity set before them. In this regard, Wellington Management considers sector return spreads offer more than adequate opportunities for return generation.

But volatility is simply one element of a very complex puzzle. Edinburgh-based Walter Scott & Partners is an investment firm that focuses on generating real after inflation return over the long-term. Right now, they think real return prospects for the next decade are in-line with what they’ve seen historically.

“It’s very simple for us. When we find a good investment opportunity, we buy it, because we see wealth generation potential, not with reference to its historic share price volatility,” says chief executive officer Alan McFarlane.

Suncorp World Equities regards volatility as a moving feast and maintains that despite the low absolute market risk, the best performing sector has still out-performed the worst by almost 40 per cent over the last year.

“More importantly, we continue to see a huge spread of returns at the stock level. This is important because Sector correlations are also quite diverse, which works to lower the headline volatility numbers unlike say, in March 2003, when correlations were tight and market volatility peaked,” says Wood.

Consistency of returns could well be more important than chasing risk. Despite volatility statistics, stock returns do move around significantly on a day-to-day basis.

Wood is confident for the future: “We’re positive there is plenty of return generating ability in the fund. I expect the unexpected when it comes to volatility.”