The pitfalls of low volatility

Ref The Economist, Jan 15, 2009

Volatility refers to the standard deviation of the returns of a portfolio. Volatility contributes to risk. Prudence demands that volatility is monitored and controlled.
But low-volatility should also ring alarm bells. Is the volatility low because the fund manager is buying illiquid assets. Because such assets are traded rarely, prices do not move much.

Or has the manager adopted a strategy with highly skewed returns; lots of small gains but the occasional catastrophic loss. Nicholas Nassem Taleb, the proponent of the Black Swan is famous for this argument. For example, the manager could be selling insurance against a big stockmarket fall. Most of the time such falls do not happen. But when the market falls, the insurer may have to pay out all his previous gains. Such strategies have been described as “picking up nickels in front of steamrollers”. Recall what happened to the monoline insurers last year.

Low volatility may also be the result of fraud. Many firms try to beat profits estimates by a small amount every quarter. Indeed one of the motivations of creative accounting is to reduce the volatility of earnings.

What we need is a change in attitude among investors. Life is volatile. Economies do not grow at a steady rate for ever. Markets do not rise at a steady pace and business conditions do not allow for a smooth rise in profits. So we must acccept volatility as a given in business. A portfolio manager who is committing high returns with low volatility may well be running a Ponzi scheme.