Lessons learnt from a roller coaster decade

It’s the time of year where many people look on the year that was, what happened, why things happened, and what we can learn and wonder what will the future hold. As it’s also the end of a decade, I thought I’d have a quick look at the past decade in risk terms.

If you invested in any developed market index at the beginning of the decade, went to the moon or some desert island and came back this week, you would’ve found that the amount in your nest egg has gone down by a few percent. You could be forgiven for thinking not much happened in the past decade. Anyone who has been around will know this is far from what actually happened. The S&P 500 rose a few percent, fell 40%, rose 100%, fell 50%, and then recently rose 50% again over the decade to end down those few percent.

Long-Term Volatility

Similar to index levels over the decade, long-term levels of volatility haven’t changed much. The three-year standard deviation of the S&P 500 was 19 in 2001. While volatility dipped in the middle of the decade, levels currently are at 20. So long-term volatility is at levels seen a few times in recent history.

Short-Term Volatility

Short term volatility is telling a different story. Using the VIX as a proxy for short-term volatility in the S&P 500, short-term volatility hit an all-time high at the end of 2008 following the credit crisis and Lehman’s bankruptcy. This was at levels double what had been seen before. While levels have returned to more “normal” levels, recent highs are still on many investors’ minds.

Risk in the Industry

For various reasons, risk has become a more frequently used term within the investment community. Recent short-term events have had a big impact on fund managers and their day-to-day decision making. Investors are asking for more and more transparency from their fund managers. One aspect of this is risk analysis so they can better manage their risk-adjusted returns. The credit crisis, Madoff scandal, Lehman bankruptcy, and other events have contributed to greater oversight from governments and regulatory authorities. Tracking Error and VaR numbers are more frequently showing up in client reports. Everyone in the industry now knows that not all swans are white.

Has this increased emphasis on risk had an impact on portfolios? It appears so. While the level of volatility in the markets is slightly higher than levels seen at the beginning of the decade, average tracking errors appear to have decreased. Consider the Morningstar U.S. Large Cap Blend peer group. Looking at the tracking error of the quartiles over time, we see that the market volatility is slightly higher than it was at the beginning of the decade.

Relative risk by quartiles is actually down. Looking at the below chart, you will see that the 25th and 50th percentile tracking error decreases from about 8 and 6 earlier in the decade, to 5 and 4 more recently. Roughly 35% decreases in relative risk with market risk up slightly. Arguments can be made if this is due to better risk management or due to managers simply becoming more passive. But it does appear that increased risk management is having an impact.

Realized Tracking Error of U.S. Large Cap Quartiles

Future

What does the next decade have in store for us? The past decade was a roller coaster ride, only to return more or less at the start. I won’t give a predication on where market levels will be 10 years from now. But considering what we’ve learned in the last 10 years, its safe to say focus on risk management will only increase, will be more integrated in investment processes and will continue to get more sophisticated.

What are your predictions?

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