Volatility and a tale of two horizons

Analysis of the FE AFI indices over two timeframes – five years and three years – reveals both similarities and striking differences in which erratic markets have played an important part.

Following last week’s FE Adviser Fund Index (AFI) article on investment timeframes, it is interesting to dig further into a breakdown of the performance.

In particular, given the recent three-year anniversary of the March 2009 market rally, we focus on the performance of the three benchmark AFI portfolios over three and five years.

One striking statistic is that despite the difficult market conditions between March 2007 and March 2009, the ratio of negative to positive weeks does not appear to change much between the two timeframes. Looking at the Aggressive index, for example, over five years the negative/positive ratio is roughly 4/5 while over three years it is closer to 2/3.

That means that on average over the past five years there would have been an average of 23 weeks of negative performance and 29 weeks of positive a year. This compares with 21 negative and 31 positive weeks a year on average over the past three years. (AFI continues below)

However, despite the relatively similar ratios, the performance outcomes are radically different. The Aggressive index returned only 18.13% over five years, whereas it has returned 59.44% over the past three years.

What this demonstrates is the high degree of market volatility the portfolios have endured over recent years. The difference in performance can be attributed to the fact that during the negative weeks between March 2007 and March 2009 the portfolios dropped considerably more than they did during negative weeks in the following three years.

What it also displays, however, is that the picture is not as clear cut as investors would ideally want it to be. Over those same two years of heavy falls there were 52 weeks, or the equivalent of an entire year’s worth, of positive performance. That suggests there was still money to be made for the active investor.

“Clients’ time horizons should be quite long, but advisers need to be more cognisant of market volatility,” says James Davies, a portfolio manager and fund research specialist at Close Asset Management. “At the moment it’s all about eking out relative outperformance by sweating the assets that little bit harder.”

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Unfortunately, the nature of the financial crisis meant that performance of the three AFI portfolios differed far more on the upside than on the downside. In the two years to March 19, 2009, the Aggressive, Balanced and Cautious indices fell 25.91%, 24.46% and 22.25% respectively.

However, in the three years from that date they have rallied by 59.44%, 50.35% and 42.71%, giving a spread of 16.73% versus the 3.66% between the best and worst-performing portfolios over the preceeding two.

This, perhaps, reveals the extent to which markets were sold down indiscriminately during the crisis. Yet if an investor had pulled out early in 2007 and moved into cash or cash equivalents the story would be quite different again.

Between March 2007 to March 2009 cash/money market products delivered an average return of 5.24%, according to FE Analytics. This would have meant outperforming the FTSE 100 index of Britain’s leading shares by some 38.45% and the AFI’s leading Cautious portfolio by 27.49%.

This is not to advocate taking huge bets with investors’ money based on historical returns. It would be a brave investor who would move into cash at present, with interest rates at record lows and inflation sticking well above the Bank of England’s target of 2%.

Nevertheless, it illustrates again not the importance of headline performance figures, but how these numbers were achieved. It also, once again, shows that there remains a strong positive correlation between risk and return over the longer term but that this does not always apply over shorter time horizons.

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“You’ve got a number of forces at work,” says Tim Cockerill, the head of collectives research at Rowan Dartington. “Invariably, investors wouldn’t have made the decision to buy into the market at or even near its lowest point, and that’s perfectly understandable. But hindsight colours things and it’s that dynamic that allows people to focus on the three-year numbers.”

The old debate about investor time horizons is as pertinent now as it ever was. The returns of the past three years are highly unlikely to be repeated, while risks to the global recovery have also been growing.

What is most important is that those investment houses or advisers that may be tempted to push stories of stellar short-term returns tread carefully. Managing expectations during bull markets can be just as important to retaining clients as protecting their capital when markets turn.

Nothing erodes trust quicker than a promise unfulfilled.