Download How Does Market Volatility Impact Risk Measures?

How Does Market Volatility
Impact Risk Measures?
Paul D. Kaplan, Ph.D., CFA, Quantitative Research Director, Morningstar Europe
The aim of the SRRI, to provide investors with a standardised measure of risk, is a
noble ambition but are there improvements to be had?
In this, the first of a series of articles from Morningstar
Director of Quantitative Research Dr Paul Kaplan the
author discusses the options for creating a universal
risk ‘metre’ that will act as a useful guide for individual
investors without misrepresenting the complexity of risk
as a concept.
The European Securities and Markets Authority’s
(ESMA) proposed Synthetic Risk Reward Indicator or
SRRI for the Key Investor Information Document (KIID)
has the noble ambition of providing the ordinary
investor with a simple measure of risk. There can be no
doubt that this is a laudable goal, as theory and practice have proven that the risk of an investment can be
difficult to grasp for even sophisticated investors.
Ultimately, explaining complex and technical concepts
like risk in a straight-forward manner requires some
compromise to “keep it simple” both in calculation and
presentation. This is especially true when considering
the impact various investment strategies and product
structures have on the final investor experience. To the
point, this is not easy to do in a formulaic manner—
something has to give.
The current specification for calculating the SRRI is a
great start. But we’ve asked ourselves at Morningstar,
based on our experience and skill at devising just such
intuitive presentations of difficult concepts: are there
ways to improve the result of the SRRI methodology for
investors without adding undue complexity?
As you might have guessed by now, we came up with
some possible answers to this question. Over the
1
course of the next several months, through research led
by our best quantitative minds we hope to open a
discussion on the merits of some possible improvements.
To start, we recommend that “Reward” be dropped
from the SRRI name. While taking risk might be a
necessary condition for reaping the long-term rewards
of investing, it is far from a sufficient one. In fact, most
risk goes unrewarded. This is why modern portfolio
theory teaches us to diversify our portfolios to avoid
taking risks that will not be rewarded.
We start our analysis by considering the fixed boundaries specified by ESMA for the risk scores. Fixing
these cut-off points at once makes both the calculation
easier to perform and provides some consistency—
consistency in process that could help investors
understand the outcome better. However, having static
boundaries creates its own issues when overall market
volatility shifts dramatically.
See Chart 1 for an illustration of this point. We took
generally accepted representative market indices for
equity, fixed income, and money market asset classes
and plotted their weekly rolling 5-year volatility
according to the ESMA specification. The fixed horizontal bands represent the fixed breakpoints for
translating volatility into the risk score, which is an
integer between 1 and 7. As you can see from Chart 1,
the major market disruption at the end of 2008 caused
by the financial crisis altered the landscape, especially
with the equity indices representing European shares.
How Does Market Volatility Impact Risk Measures?
Paul D. Kaplan, Ph.D., CFA, Quantitative Research Director, Morningstar Europe
Key
MSCI Euope NR EUR
BarCap Euro Agg Bond TR EUR
MSCI France NR LCL
Citi EUR EuroDep 3 Mon EUR
MSCI Germany NR LCL
Chart 1
30 Standard Deviation
Level 7
Our concern with fixed boundaries is that without a link
to the underlying market volatility, investors might be
alarmed to learn that within a few short weeks many of
their funds shifted from a risk score of 5 to a risk score
6, one step away from the most risky investments available in the market by this measure. Even at the low end
of the risk spectrum, LIBOR is close to moving from a
score of 1 to a score of 2. This means that under certain
market conditions it might be difficult for investors to
find an investment with a risk score of 1.
25
20
Level 6
15
Level 5
10
Level 4
5
Dec 07
Level 3
Level 2
Jun 08
Dec 08
Jun 09
Dec 09
Jun 10
Dec 10
Chart 2
30 Standard Deviation
Level 7
25
20
Level 6
15
Level 5
10
Level 4
5
Dec 07
2
Jun 08
Dec 08
Jun 09
Level 3
Level 2
Dec 09
Volatility spiked in a very significant way, which is not
news to anyone. What is interesting is both the
dramatic immediate shift and the enduring impact this
shift has had on the risk scores for these equity asset
classes.
Jun 10
Dec 10
A possible solution to the problem of dramatic shifts in
risk scores is to use boundaries between the risk scores
that adjust based on the underlying market volatility.
Chart 2 shows the effects of doing this. Granted this
adds some additional complexity in performing the
calculation, but we feel it is worth it to ask the
experts—the fund companies—to do a little extra work
so that investors don’t have to. As you can see, by
adjusting the cut-offs these same equity indices remain
much more consistent in their risk score. Trading the
consistency in the cut-offs for consistency in ratings, yet
still providing a useful measure for investors in a way
that is easier to understand.
An additional advantage of tying the risk score breakpoints to market indices is that the way the breakpoints
vary can be linked to a specific currency. In fact, this is
what we did to create Chart 2. The reason that we only
show the indices that are denominated in Euros in the
chart is that breakpoints are tied to a Euro-denominated
index. Investments with returns denominated in, say,
Pound Sterling would have breakpoints that are tied to
an index that is denominated in Pound Sterling. This will
be the topic of the next article in this series— a more
detailed look at how currencies can impact SRRI score.