Risk is a critical part of successful investing. Selective exposure to risk is needed to achieve most investors’ goals. Yet, risk means different things to different people. Even when you flesh out a client’s risk profile, appropriately measuring risk is a significant challenge. Here are some practical realities pertaining to the thorny issue of risk.
With today’s low interest rates, seemingly everybody is reaching for yield. Many are looking to dividend-paying stocks as an alternative to low-yielding bonds. Even within the bond market, promotions of investments that promise high returns — such as corporate bonds, high-yield bonds, emerging-markets bonds and private mortgages — are flooding financial advisors’ inboxes.
But advisors should keep one fundamental rule in mind: there is no free lunch. With 10-year Canada bonds yielding about 3.5%, any investment with the prospect of higher returns always comes with additional risk exposure. The key is understanding the embedded risks.
For example, private-mortgage funds are enticing today, thanks to yields in the 7%-8% range. Ironically, such funds’ most attractive trait is also their biggest potential risk. The ads for many such funds show a chart depicting a steady, smooth net asset value per share. But as interest rates bounce around, the NAV line will not be so smooth.
A mortgage is a debt, just like a bond, and the NAV should fluctuate with changes in relevant bond yields. Mortgage fund sponsors may argue that the value of the mortgage loan hasn’t changed if there is sufficient security backing the loan. But if the borrower hits hard times, the loan could go into default and the underlying security — often, a building — either may not be sold quickly and/or at a high enough price to cover the loan balance.
If a mortgage fund has not yet experienced such an event, its NAV line will not reflect the possibility that it can happen in the future. Yet, it’s a risk that should be considered and discussed.
I wouldn’t blame advisors for being dizzy from the all of the statistics in marketing material and on websites. Everything from alpha, beta, Sharpe — and the list goes on. Some of these metrics use risk to calculate a risk-adjusted return figure. Others, such as beta, have become known as a risk measure — a misused one, in my view.
Beta’s calculation starts by taking a fund’s volatility and dividing it by the benchmark’s volatility. That result is then multiplied by the correlation of the fund to the benchmark. A fund can be 50% more volatile than the index and have a beta of less than one if it’s not highly correlated with the index. But that doesn’t make it less risky. It just means that a lot of its risk exposure doesn’t come from the securities in the benchmark used in the calculation.
Approaching sales pitches with common sense and understanding what risk statistics measure — and what they don’t — can save you a lot of grief the next time the bear rears its head. IE