Income And Growth Survey: Assessing a risky business

Measuring fund volatility is not the perfect science some would have us believe.

PERHAPS YOU are put off by the idea of a risky investment, or decide that you like it if added risk also opens the prospect of higher- than-average gain. Whatever your preference, finding a usable definition of investment risk is not so straightforward.

For most of us it means losing or gaining on the cash value of an investment. This is a common-sense, short-term measure of risk in absolute terms.

But given the cyclical behaviour of equity and bond markets, investment advisers warn against its use. Today's fall can easily become tomorrow's rise in value.

Mike Lenhoff, head of strategy at Capel Cure Sharpe, says: "Most measures of investment risk come down to looking at the relative volatility of a fund against one or another yardstick.

"There are a number of ways to do this. Performance can be relative to same-sector funds, or a performance benchmark, or a share index such as the FTSE 100, which measures change in value of the top 100 shares traded on the Stock Exchange.

"Some of these ways of measuring volatility make more sense than others, and much depends on relating these to your particular goals as an investor. The time scale over which you judge risk is also very important. Over the long term - say 15-20 years - riskier investments should give higher returns than less risky ones in the same asset class."

If you study the past performance of unit or investment trusts you will find them grouped together into like categories against which past performance and volatility can easily be measured. "Fund volatility" is one way of quantifying risk.

Typically, this is measured over 36-month periods using a particular fund's "standard deviation" from average return for all funds in its category.

A fund with above-average volatility for its sector offers greater potential for gains or losses against other funds with a lower rating.

Richard Hughes, fund manager of M&G's Recovery unit trust, explains: "If a fund has a volatility rating of five, and its sector rises by 10 per cent in value over three years, then in it should grow in value by between 5 and 15 per cent over this period."

"A fund in the same sector with a rating of three should fluctuate across a narrower band from 7 to 13 per cent. In each case the rating is both deducted and added to sector growth to predict a fund's likely range of behaviour."

Clearly, the value of volatility ratings depends in part on how the similarity of the funds classed together into an investment category. A couple of examples should help illustrate this point.

The UK Equity Growth category of unit trusts includes some 174 funds, all primarily invested into the UK. Average volatility for these funds over three years is 3.88 (source Reuters-Lipper), ranging from the lowest rating of 1.33 to the highest of 6.75. Most funds have ratings of 3.5 to 4.5.

But the "asset allocation" of shares held in these funds can vary widely. M&G's Recovery Fund is an example with a volatility rating of 4.25, 45 per cent of its value in FTSE 100 shares, 40 per cent in mid-cap shares and 15 per cent in small-cap shares.

Elsewhere in this category, Invesco's UK Blue Chip fund has a rating of 4.12 but holds just 12 per cent of its total value in Mid Cap shares, with 78 per cent in FTSE 100 shares.

"The value of these ratings depends partly on the diversity of asset allocations permitted to funds classed in the same category," argues Lenhoff. "Some of these categories are far more tightly defined than others."

This can be shown by comparing the UK Growth category to the UK Smaller Companies category. Both of them require their member funds to have at least 80 per cent of their assets invested directly in UK shares.

The Growth category stipulates that member funds be run for capital growth, but stipulates nothing about the capitalisation of shares held in the fund. However, to qualify for membership of the Smaller Companies category a fund must hold all of its UK equity component in Small-Cap UK shares. This is regarded as the most volatile, highest risk class of share traded on the Stock Exchange.

There are only 79 funds in this category, with an average volatility of 4.4. But the lowest and highest ratings for individual funds go from 3.49 to 5.81, with nearly all funds rated between 4 and 4.7, a far narrower range than in the larger, less risky Equity Growth category.

In addition, the average returns on pounds 1,000 invested into UK Smaller Company funds has been just pounds 918 over the 12 months to 26 February 1999, while for Growth Sector, the average returns have been pounds 1,069.

What this shows is that measuring volatility alone proves very little about the likely performance of a sector. "Past performance comes first," argues Hughes, "and only then should you take account of volatility when making a choice between funds."