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Category Rank and Volatility

Discussion in 'Managed Funds & Index Funds' started by _Sharon_, 13th Feb, 2007.

  1. _Sharon_

    _Sharon_ Active Member

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    Hi,

    I am trying to understand the performance table on the DirectAccess site and I'm not sure excactly what the Category Rank is? I'm assuming it has something to do with the position the fund is against like funds? Also the volatility, how is that worked out? I know the lower the number the less volatile the fund is and I've seen ones as low as .01 but how high do they go?Could someone please explain it? Thanks



    Thanks in advance

    Sharon
     
  2. iiinvestor

    iiinvestor Well-Known Member

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    Sharon:

    I haven't checked out the site, but rank is probably the Assirt or Morningstar rating. So you're right in assuming it is a comparative rating of funds. It's up to you if you want to take notice of it, but all I'd suggest is to not put too much emphasis on it.

    As for volatility, it refers to the range, standard deviation or variance of the unit prices over a period of time. There's actually a difference between range, std dev, variance, etc, but don't worry about that for now. Just accept that it is a measure of how stable/unstable the unit price/returns are.

    For example, you may buy into a fund at $1 per unit. Over the next year the price may be $1.10. So you've seen a return of 10% approximately. However, the price could have been $0.50 after three months, $2 after five, $0.70 after nine and then finally $1.10 after 12. Although you may think it produced a nice return of 10%, it was almost pure luck due to the volatility of the fund.

    Another consequence of volatility is that buying at the wrong time may be catastrophic. From the example above, imagine you bought in at $2. Based on the final return of 10% (on the original $1), it could be 6 or 7 years until you got your money back.

    Generally, the financial community views volatility as a direct display of an asset's risk. I could debate that, but let's leave it at that for now.

    To extend on this, people generally consider the return on an asset in light of the volatility/risk. For example, Fund A has a return of 10% and volatility of 0.1, whereas Fund B has a return of 12% and volatility 0.5. While Fund B has a slightly better return, its volatility is much higher. So it's up to you to decide if you're willing to take on that extra risk for an extra 2%. At face value, I wouldn't, but in reality the figures would be much closer and harder to discern.

    If you want to get more technical about it, check out the Sharpe Ratio. It's a simple calculation using return and volatility that results in a number that you can use to compare against other investments/funds.

    Hope that helps. :)
     
  3. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Beyond what iiinvestor explained - you also need to consider what the fund is investing in. There are funds which invest in a wide range of shares, and there are others which are very specific and focussed in their investments. Some invest in a particular market sector (eg Healthcare, Resources, Listed Property etc), others invest in a particular index, or index segment (eg Blue Chips, Small Caps, Dow, etc), and others still invest in a specific geography (eg Australia, US, China, Asia, etc).

    Every one of these variations will have an impact on the volatility of the fund - for example, right now, Resources are volatile on a global basis due to the volatility in commodity prices and speculation about the continued growth and demand for resources in China and the region. That doesn't mean that you can't make money from these shares and funds, quite the contrary - there are great opportunities for making a lot of money very quickly (volatility isn't just a downwards measure, it's a movement measure in both directions). The trick is knowing which way the movement will be and whether you are prepared to "hang on for the ride" or think you can time your entry and exit to maximise your returns (or minimise your losses !!).

    In general, the more focussed a fund is, the more volatile it would be (there are many exceptions to this though), since you are, to a degree, "putting all your eggs in one basket" and more likely to see larger swings when that particular portfolio is impacted by the same external force (eg increasing interest rates, a natural disaster, changes in the law). Conversely, a fund which invests in a widely diverse range of shares will not likely be as volatile, since many markets are counter-cyclical (when one is up, another is down and vice versa) ... thus they even themselves out. This is part of the theory of diversification anyway - all with the aim of reducing volatility and risk.

    All sharemarket investments are volatile - there is always the possibility of negative years - it depends on how you structure your portfolio, and what your goals are, as to whether this is actually a problem. Compare to a term deposit investment - there is basically zero volatility over a given term, the return is known in advance, and there is no variation in that return. But it's also pretty boring too :D
     
  4. _Sharon_

    _Sharon_ Active Member

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    Thanks for that iinvestor and Sim.

    That helped but it is all so much to take in. The Sharpe Ratio had my head spinning (too much to focus on it right now as I keep an ear out for my girls:) )

    I understand more now about how volitility relates to the years ups and downs, thanks.
    But how do you pick when to enter a fund? I thought I choose one I liked with the returns I wanted and buy into it? Is buying into a fund more timing sensitive just when it is a higher risk fund? Like for Australian share funds, you'd have to believe the market will continue to go up to buy in at this stage? whereas if I'm looking at a more balanced fund across all classes, the timing less important? But then aren't the returns on Aust shares funds also made up of dividends, not just growth and capital gains? So if the shares have good dividend returns then there is still returns there? Which brings me to another question I have....imputation funds....what are they? Are the returns from these funds more from dividends than anything else? Or am I completely off track?

    Thinking a bit more I realise yes, the timing is less important of on a more balanced less risk fund because it would have less risk of being down at any particular time....of course, that makes sense.....I think I am getting it......slowly:D


    Thanks
    Sharon
     
  5. iiinvestor

    iiinvestor Well-Known Member

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    Sharon:

    That's part of the gamble, unless you have additional info. But if the fund has reasonably low volatility (which most generally do) and you're a long term investor, it won't matter so much. My example was a gross exaggeration for the sake of demonstration.

    You've already said your head is spinning, so I'm not sure how far to take this one. But remember past performance won't necessarily reflect on future performance. With that said, you're not going to pick a fund that has done minus 10% for 10 years straight, but... chances are if you pick the top performing fund this year, it will be far from the top performing fund next year or in 5 years. Obviously your next question will be 'so how do I choose a fund?' But that's the $1m question and probably deserves its own thread.

    Short answer: pretty much.

    Yeah, all correct. About the dividends, the average dividend yield is probably about 3%. So while that's always a bonus, you would be investing in hope that you would also see growth. Inflation alone will wipe that 3% out, so you'd be better with your money in the bank if you only expected dividend returns for a long period.

    Yes, fully and partially franked dividends in particular. I'm sure there are many variations on imputation funds, but as you suggested the idea is to invest in assets that return a higher than usual franked dividend income.

    Yeah, you're completely onto it. Maybe leave the Sharpe Ratio for another day. :D
     
  6. _Sharon_

    _Sharon_ Active Member

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    Thanks iiinvestor, good to know I'm getting some things right in my head. Defiantely will leave the Sharpe Ratio for another day!
     
  7. AndrewG

    AndrewG Well-Known Member

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    Any takers for both these two topics?

    Andrew.
     
  8. Tropo

    Tropo Well-Known Member

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    I am not dealing with fund's ;) but I would check fund's performance during the bad times. During boom everybody is making money, and during bear time almost everybody is losing money.
    Also, would be good to know how many directors are running company, for how long, and how much each of them is earning.
    Next step, check markets they trade/invest in, their risk/money management philosophy etc..

    But again .... as you know past performance does not guarantee future one.

    Sharpe Ratio:
    The Sharpe Ratio
    Sharpe Ratio
    Sortino ratio - Wikipedia, the free encyclopedia
    :p
     
  9. iiinvestor

    iiinvestor Well-Known Member

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    Just to extend on Tropo's post with an example:

    The sharp ratio is: (return - risk-free rate)/std deviation

    We can use it to easily compare funds and come up with the best one in terms of risk vs return.

    Let's assume the risk-free rate is 6%. Just FYI, the risk-free rate is the rate that someone with absolutely no risk can borrow money. Remember the more risk you have, the more people will charge you for borrowing. So while you and I can borrow at about 7%, people with a bad credit history may be charged 9%. Well, no one is really risk-free, but the government is pretty close to it (since they have lots of money and can print money if they really need it). There's more to it as usual, but for the sake of this, the risk-free rate is the rate at which the government can borrow. We just need it for this formula, so don't worry too much.

    The part of the formula on top - the numerator - that says (return - risk-free rate) is just finding the part of the return that is more than the risk-free rate. In other words, it represents the risk of the asset over and above government (riskless) borrowing. We call this the risk premium. So if the risk-free rate is 5% and the rate at which we can borrow at is 7%, our risk premium (because we are more risky) is 2%.

    Annnyyyywayyyyy...

    Let's say the risk-free rate is 5% and we have the following funds:

    Fund A: return = 10%, volatility = 0.1
    Fund B: return = 15%, volatility = 0.25
    Fund C: return = 30%, volatility = 0.55

    We can now work out the Sharpe Ratio for each (the higher the better):

    Fund A: (0.1 - 0.05)/0.2 = 0.5
    Fund B: (0.15 - 0.05)/0.25 = 0.4
    Fund C: (0.3 - 0.05)/0.5 = 0.45

    So from this we can see that Fund A has the best risk/return profile and Fund B has the worst. As you can see, it's a really basic calculation that can help compare funds. If you looked at those funds without the calculations, it would be hard to tell which one is best on a risk vs return basis.
     
  10. tasmo

    tasmo Well-Known Member

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    Hi iiinvestor,
    Directaccess.com.au provides a useful funds search facility and fund statistics. Within those statistics is a volitility rating as a whole number, eg; Navra 1.68 for last 12 months (very stable) and say Perpetual Wholesale Geared Austalia Fund which very volitile at 7.16.

    I would like to plug the directaccess volitility figures into the Sharpe return/risk formula. Any hints on converting the volitility number into standard deviation.

    thanks
     
  11. iiinvestor

    iiinvestor Well-Known Member

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    hmmm... I'm not sure what they're using for volatility. I had a look all over the site, but can't find definitions. The numbers look a lot like beta calculations. But that doesn't really make any sense. I'll send them an email.

    Just say we never find out though, you could still use that number. The result you get from the Sharpe Ratio doesn't have any significance by itself. It's just used to compare to others. So if the volatility from direct access does represent risk somehow, you could still use the number and compare with other numbers (where you've used that same volatility measure).

    Hopefully they get back to me though.