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Understanding volatility
05 Sep 2022

The events that unfolded earlier this year have caused international markets to become turbulent. Recent data revealed signs of stability and noticeable positive momentum; however, the outlook remains uncertain as inflation still lingers while global demand retreats, triggering recessionary fears.

An important measure of risk that requires monitoring is volatility, which portrays the dispersion of returns. The higher the volatility of a security, the riskier it is, as its price can vary both ways by a high magnitude.

In times when volatility is stable, market outlook can be more predictable; however, once it rises, uncertainty follows. Market volatility can be analysed through the VIX Index, enabling investors and portfolio managers to understand the level of risk.

The easiest and fastest way to reduce volatility is by shifting aggressive holdings to cash, the safest asset class. Such a strategy could prove to be detrimental in the medium to longer term, as when markets rally, a portfolio invested heavily in cash will miss out from reversals and end up purchasing securities at higher prices.

An effective way of controlling volati­lity is through risk spreading, in other words, diversification. Here a portfolio will consist of a mix of asset classes and spread further by combining holdings in different sectors, regions, duration, multi-asset funds, etc.

The purpose is to reduce concentration, so that when certain securities fall, the rise in others will average out the outcome. Say portfolio A holds one security and it falls by five per cent; the loss is five per cent. By contrast, portfolio B holds two securities in which one security falls by five per cent while the other increases by five per cent. Portfolio B will register no movement.

It is essential to note that, albeit having a diversified portfolio, systematic risk can potentially hinder performance given its inherent nature, reflecting economic distress such as the global financial crisis and COVID-19. However, history has showed us that markets were resilient and recovered following the crises.

Portfolio managers and advisors, during periods when markets are ‘bearish’, closely monitor the risks in each sector and industry before taking investment decisions, as certain sectors tend to perform better than others.

As a reference, the portfolios are compared against their respective benchmarks to determine whether they have an over- or under-weight position in the said sectors or industries. Adjusting allocations could restrain volatility as a mix of securities and positions add correlation benefits.

“Investors can either halt their losses or seize the opportunity in anticipation of a market rally.”- Matthias Cardona

The Synthetic Risk and Reward Indicator (SRRI) assists investors in monitoring the level of risk engaged in by a fund, ranging from 1 (lower risk, lower return) to 7 (higher risk, higher return).

The indicator is a measure of volatility considering weekly or monthly returns of the past five years of a fund, and the resultant figure will correspond to an integer number of the SRRI based on the volatility intervals set by the CESR (Committee of European Securities Regulators). Naturally, an equity portfolio will have a higher SRRI than a fixed income portfolio.

Nowadays, we are noticing portfolios whose SRRI increased due to market volatility; however, one must keep in mind that the calculation of the SRRI still considers the COVID-19 period, representing a spike in volatility.

This means that the volatility calculation for SRRI purposes has not yet moved back to normal levels and volatility figures remain elevated, almost exceeding intervals.

It can be argued that if portfolios remain in line with their investment strategy, prospectus rules and policies, it is systemic risk that is attributing to high levels of volatility and uncertainty as all asset classes were impacted negatively. Even low-risk portfolios may seem riskier where underlying securities are of a conservative nature.

In a market environment such as the one we are experiencing today, investors can either halt their losses or seize the opportunity in anticipation of a market rally.

Matthias Cardona is a risk analyst at BOV Asset Management Ltd.

The author and the company have obtained the information contained in this article from sources they believe to be reliable, but they have not independently veri­fied the information contained herein and therefore its accuracy cannot be guaranteed. The author and the company make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in the article. They have no obligation to update, modify or amend the article or to otherwise notify readers thereof if any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. BOV Asset Management Ltd is licensed to conduct investment services in Malta under the Investment Services Act by the Malta Financial Services Authority. Issued by BOV Asset Management Ltd. Website: www.bovassetmanagement. com. Source: BOV Asset Management Ltd.

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