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Category Investments

Returns and risk

28 October 2004 Angelo Coppola

Beating benchmarks and achieving above-inflation or optimal investment returns in increasingly volatile and competitive investment markets are the challenges facing investment managers, who are often judged on performance returns.

However, performance is not just about returns - risk must also be taken into consideration.

Brendan Howie, head of quantitative research at Investment Solutions, says that because of the emphasis on returns, investment performance relative to risk is sometimes mistakenly overlooked.

A more accurate assessment is achieved by combining risk and return in a single number - such as the commonly used information ratio - which measures risk-adjusted performance. It relates to a defined benchmark, usually set by the investor, trustees or an investment consultant, and indicates how managers have performed relative to the risk taken to achieve the returns.

"A high information ratio with low returns is not an optimal situation for most investors, as it indicates that a manager has been rewarded for taking benchmark risk. A negative information ratio means the manager has lost value against a benchmark," says Howie.

A low information ratio implies an investment manager is taking excessive risk to achieve superior returns and is also an indication that the investor's assets are not being deftly managed, he says.

Howie explains that a high information ratio with high returns is the most desirable result and can best be achieved through multi-managers, which skillfully and objectively select appropriate investment managers to create an optimal portfolio mix for investors.

"Diversification of managers and assets reduces investment risk. Information ratios at the fund level can be improved by using a diverse selection of appropriate and optimal investment managers selected by a multi-manager," he says.

By diversifying the decision-making process, ie asset allocation and investment managers, investors can expect their information ratios to improve. Multi-managers monitor investment managers' performance through a sophisticated portfolio analysis system, thus reducing and controlling the investment risk.

At the asset-allocation level, this may mean the addition of a model to determine the appropriate benchmark asset allocation, and appointing expert advisers to assist with more tactical aspects of asset allocation. More efficient asset-class benchmarks can also improve the return success rate.

"Diversification across investment managers results in lower tracking error, ie bet sizes taken against a benchmark.

Consequently, a multi-manager is able to control risk by allocating assets to different investment managers. Thus, the approach of limiting tracking error within a particular investment manager's mandate is not always necessary, as the overall tracking error will generally be lower for the multi-managed fund," says Howie.

An allocation to different manager styles will improve the consistency of fund returns. Investment manager selection within each style and manager blending is still vital to ensure overall performance and high information ratios are maintained, says Howie.

Health warning: Get expert advice when making specific investment choices, and if in doubt, get a second opnion.

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