Page 112 - Profile's Unit Trusts & Collective Investments - September 2025

Chapter 6 Investment risk

Alpha
By introducing stock picking risk and other fund manager risks, active fund management often
increases the overall riskiness of a fund – at least compared to its benchmark. (Sometimes, of
course, active fund management can decrease riskiness, although this is less common.)
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 on next page).
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 Table 6.1 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%.

110 Profile’s Unit Trusts & Collective Investments September 2025