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

Investment risk Chapter 6

tightly held and a fund heavily invested in illiquid shares might find itself relatively “locked in” in a
bear phase.
The issue of liquidity levels within funds is a more important one. Collective investment schemes,
even those classified within the same sectors, sometimes have different mandates with regard to
their overall liquidity levels. Some mandates require the fund managers to be as fully invested as
possible, while others are permitted to operate within the requirements of the ASISA guidelines,
which would allow, for example, a general equity fund to be as much as 20% liquid. Liquidity can
have a significant impact on performance.
A general equity fund which is 20% liquid in a bear phase is not as exposed to the falling market, but
the same liquidity level in a strong bull phase will almost certainly cause the fund to underperform.

Stock picking risk
As we said earlier, having all your eggs in one basket is a great strategy – provided you pick the
right basket.
One way to achieve superior returns is to concentrate your investments in a smaller number of
winning shares. This is something that Warren Buffet is famous for, and his wealth is testimony to
the success of this strategy. There is no question, however, that all things being equal, concentrating
on a smaller number of stocks generally increases the risk level. Stock picking requires in-depth
knowledge of the market, the economy and particular companies.
Stock picking risk can, of course, be reduced through diversification. Index funds are an effective
way of almost eliminating stock picking risk, because they aim to mirror the performance of a market
index and are therefore only exposed to particular shares to the extent the index itself is exposed.
When it comes to actively managed equity funds, which rely considerably on stock picking, the
proven track record of the fund manager is an important consideration.
Measuring risk
As mentioned earlier in this chapter, risk is hard to define – the word means different things to
different people. How to measure or quantify risk can, therefore, be a contentious issue.
Some common measures of the riskiness of unit trusts are volatility, beta, alpha, maximum
drawdown and r-squared. (Ratios like Sharpe and Sortino also address risk but provide risk-adjusted
returns rather than “pure” risk measures.)

Active returns
The types of risk covered in the previous section can broadly be divided into two categories: on
the one hand, risks inherent in assets classes and where they are domiciled, and on the other, risks
associated with decisions made by fund managers and investors.
As we have seen, the performance of asset classes (and sectors or sub-divisions within assets
classes) are measured by indices which are used as performance and risk benchmarks. A long
term investment which replicates an index or benchmark, known as a passive investment, is mainly
subject to benchmark risk – ie, because the investor or fund manager is simply riding the ups and
downs of the asset class or sector, the risk factors associated with stock picking and market timing
are minimised or precluded.
The investment returns produced by a particular asset class or sector (as measured by a
benchmark) can be referred to as passive returns – ie, the investment performance inherent in the
benchmark. An active return, by contrast, is the difference between an actual investment return and
the return of the investment’s benchmark. This active return must be attributed to decisions made by
the fund manager or investor (ie, the active return is the result of active management).
The concepts of passive and active returns are important in the unit trust industry because the role
of most fund managers is to achieve active returns – to outperform benchmarks. (The exceptions
are “passive fund managers” but this term is almost a misnomer – the manager of a passive fund
is not so much “managing” the fund as ensuring that it conforms to a benchmark.) Investors in an
actively managed fund are, as a rule, hoping for performance in excess of the benchmark.

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