Page 111 - Profile's Unit Trusts & Collective Investments - March 2025

Investment Risk

Alpha is a risk-adjusted measure of the active return of an investment. Technically, it is the
difference between an investment’s expected return, based on its beta, and the actual returns
achieved. Hence alpha can be thought of as the value that the fund manager contributes to the
investment return. Of course, alpha can also be negative (ie, when a fund underperforms its
benchmark). A positive alpha of 1.0 means that a fund outperformed its benchmark by 1%, but
note that not all funds that outperform their benchmarks have positive alpha – a fund with a very
high beta can have negative alpha even though it has outperformed its benchmark. Also, because
alpha uses beta to predict expected returns, the alphas for funds with identical returns but
different betas will not be the same.
Attribution Analysis
Performance attribution, or attribution analysis, refers to various techniques designed to work
out the causes of a portfolio’s active return.
For example, on the assumption that portfolio returns differ from benchmark returns mainly
because of asset allocation, stock selection and market timing decisions, attribution analysis
typically seeks to apportion the active return to these different effects. In other words, performance
attribution analysis tries to explain how much of the active return was due to the different type of
investment management decisions made by the fund manager.
The goal of attribution analysis, over time, is to evaluate the skills of fund managers and to
differentiate performance that is the result of luck rather than good judgment.
Volatility
One of the most widely used measures of risk is volatility. Volatility measures the extent to which
an asset’s price goes up and down (or fluctuates around an average). A fixed deposit paying 8% per
annum has zero volatility: at any point in the year the average return, the expected return and the
actual return are all the same. The price of a share is much less certain: it could be up or down next
week or next month, and even a year from now there is no guarantee the price will be higher.
Technically, volatility is calculated as the standard deviation of monthly returns (ie, monthly
gains or losses), usually over three years. This figure, which gives an indication of the monthly
“variability” in returns, is usually annualised to show the average fluctuation over a year (see box
below). Volatility (provided it is calculated on a consistent basis) is comparable across funds and
securities because it is based on percentage movements, not price.
The volatility figure can be thought of as a range or a “band” around the average return. The
figure tells you that, two-thirds of the time, fluctuations in returns have fallen within this band. If
you double the figure you have a “band” which covers 95% of monthly price fluctuations (both up
and down), and if you triple the figure there is slightly less than a 1% chance that any monthly
fluctuation will be greater. Given a fund with historic volatility of 2.0, for example, there is a 99%
chance that the next month-end change will be between +6% and -6% and a 95% chance it will be
between +4% and -4%.
If the fund’s price is 100c now, there’s only a very small chance that the price in a month’s time
will be greater than 106c or lower than 94c. By contrast, a fund with a volatility of 8.0 carries a
definite risk (about a 33% chance) of falling to 92c or lower in a month.
The above concept is better explained with an example. Consider Chart 6.2 which shows the
returns for two different investments over a 20-month period.
Although the average return is comparable, the Risky Co. Ltd. shows a far greater variability in
its returns. The standard deviation indicates that most of the returns (in fact, 67% of the time) will
be between 12.87% and 16.75% (average of 14.81% minus and plus one standard deviation) while
the Stable Co. Ltd. investment returns will most of the time vary from 14.04% to 15.62%.
Should the investor choose a period at random and invest in the Risky Co. Ltd., he may attain a
return as high as 18.78% compared to the highest return offered by the Stable Co. Ltd. of only
16.17%. On the other hand, the investor in Risky Co. Ltd. runs the risk of having a return of only
11.70% compared to the lowest return of 13.51% shown by the Stable Co. Ltd. The difference in

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