Market volatility this August caused many asset classes to be in the red when viewed over the year to 30 September 2015.
We’ve long believed that to evaluate asset classes over long periods its more helpful to look at a measure of the risk-adjusted returns (such as the sharpe ratio) than pure returns – you can find our Q3 2015 update of the sharpe ratios of many asset classes here.
Terms such as “Sharpe ratio” can sound like jargon but really what it means is how smooth the investment ride has been. Nirvana of course is an asset that goes upward in a straight line with never a bump in sight. That doesn’t happen of course but the sharpe ratio tells us important information about how “bumpy” the ride has been (or will be). A sharpe ratio of 0.1 say, is pretty bumpy – you will have to endure a lot of ups and downs to earn the return. A sharpe ratio of 1 or greater is a pretty smooth ride, any setbacks are probably quickly recovered.
When viewed through that lens, over the last 5 years the picture is still pretty favorable and the medium term trend of a strong market rally at low volatility is still the dominant theme, although sharpe ratios have been somewhat hurt by the recent performance, they are still substantially above what we would expect. Equities for example have a sharpe ratio in the region of 0.6 over the last 5 years, compared to a long term average around 0.2. Generally we would expect returns to be accompanied by a lot more volatility than we’ve seen, even taking August into account. Other asset classes such as credit have also enjoyed a substantial low volatility rally, resulting in higher sharpe ratios than we would normally expect, of around 0.8 compared to longer term averages of 0.3-0.4.
If you look back over 10 years (which includes the 2008-9 crash) then over the whole period the sharpe ratio for equities is pretty in line with what we would expect (0.2).
Ultimately we would caution clients to be wary of putting too much emphasis on the return data over the last 5 years when making portfolio allocation decisions. Since the crisis we’ve seen quite an exceptional low-volatility rally across the board, and generally we would not expect such returns to be achieved at such low levels of volatility. There are three key principles of portfolio construction that we continue to believe in:
- Risk Control
- Downside protection where possible
- Diversification between a number of assets or strategies will lead to portfolios with a better risk-adjusted return compared to portfolios exposed to a single risk premia, giving a smoother ride (improved sharpe ratio)
- Employing strategies that curb exposure in times of higher risk (risk control) gives grester certainty of meeting an outcome
- Where available, strategies that incorporate downside protection will help prevent the portfolio from falling off track