Volatility Is Not a Four-Letter Word

Commonalities in Picking a March Madness Winner and a Winning Investment Team?

In each case, you evaluate the team’s performance track record, its underlying philosophy, and its success in implementing its strategy. Unfortunately, when evaluating investment funds, investors often rely on flawed analysis.

This article demonstrates why traditional risk measures, such as standard deviation and tracking error, are flawed measures when evaluating the merits of actively managed funds. We present compelling evidence that downside risk measures and the Sortino ratio are the appropriate measures for evaluating active managers.

With respect to investment analysis, the traditional risk measures assume markets are perfectly efficient and superior strategies and personnel do not exist. If you believe that picking a winning sports or investment team is more than luck, then you should avoid such measures. Applying the traditional risk measures to evaluate an active manager’s performance is a contradiction. The measures indicate how much the manager’s approach deviates from the norm, not whether the manager’s approach tips the scales in favor of the investor. Relying on the traditional risk measures is analogous to picking the favorite basketball team to win March Madness as the team that has won the most close games. That is, the team whose offense has produced a similar number of points as the average team and whose defense has given up a similar number of points. In stark contrast, the EIA team believes you should favor the team that has outscored its competition decisively in its wins and fell only slightly short in its few losses.

Unlike ‘risk’ ‘volatility’ is not a four-letter word. Risk is the necessary negative ingredient required for investors to earn excess returns. Investors must assume risk to produce returns beyond those generated by Treasury securities. The mistake investors often make is equating volatility and risk. By assessing fund risk using traditional measures such as standard deviation and tracking error, investors penalize funds for producing large investment gains.

While risk is always a negative component of the risk-return tradeoff, volatility can be a positive feature. The EIA team developed the IFED indexes with this nuance in mind. By adjusting portfolio holdings to align with changing market conditions, the IFED strategy positions portfolios to excel when normal return patterns prevail, while limiting underperformance when returns are driven by unusual forces e.g., pandemics or animal spirits. Thus, the IFED strategy is conducive to return distributions with significant positive skewness i.e., distributions with large wins and small losses.

There are two acceptable definitions of investment risk as follows.

• Definition One: The uncertainty associated with the return from an investment.

• Definition Two: The chance an investment will return less than required or anticipated.

The EIA team emphasizes definition two and believes investors should be most concerned with falling short of their investment goals. Unforeseen wins, while differing from expectations, should be relished, whether they are for your portfolio or your sports team.  

Both definitions of risk are commonly used by investors; however, the alternative definitions are often applied inappropriately. Each definition fits a particular investment scenario but is of limited use in other cases. Unfortunately, there are numerous incidents of the measures being misapplied, which we will touch on below.

Traditional Risk-Return Evaluation of Funds

Consider the investment alternatives shown in Exhibit 1 below. Returns are shown for two alternative funds and the S&P 500. IFED-LG is a large-cap, US equity portfolio maintained by EIA. The S&P 500 is considered a benchmark for each fund.

Exhibit 1. Fund Performance: 2017-2024

The returns in Exhibit 1 indicate that IFED-LG, relative to Fund X and the S&P 500, produced superior returns overall (annual alpha of 5.1% vs. 1.6% for Fund X). IFED-LG produced positive alpha in six of the eight years and had three years with particularly strong outperformance, 2017, 2020 and 2022. IFED-LG experienced no years with extreme underperformance. The performance statistics in Exhibit 1 clearly support IFED-LG as the optimal fund choice; however, as any wise investor knows, you should not judge a fund without considering its risk. 

Extending the above scenario, Exhibit 2 reports risk and risk-adjusted return statistics for the same funds over the same period.

Exhibit 2. Risk and Risk-Adjusted Returns: 2017-2024

The evidence in Exhibit 2 clouds the fund superiority decision considerably. Both funds clearly outperformed the S&P 500; however, for many investors, Fund X’s performance would be judged superior to IFED-LG’s performance. Fund X had far less variability and tracking error and matched IFED-LG on risk-adjusted performance.

For some investors, IFED-LG, with its double-digit tracking error, would be immediately discarded based on having “too much” risk. In the next section, we will detail why such a decision is ill-advised.

How Should Fund Performance Be Judged?

Based on the return statistics in Exhibit 1, IFED-LG was superior over the period evaluated; however, based on the risk statistics in Exhibit 2, the superior fund for many investors would be Fund X. The EIA team contends that the above performance evaluation, and preference for Fund X, misses the mark.

The EIA team believes that the above analysis contains a fundamental flaw. That flaw is that the two risk measures considered in Exhibit 2 rely on the underlying principle that each fund manager had limited investment skill. That is, any outperformance produced in a year was largely a random occurrence and could have just as likely been underperformance. The two risk measures consider the first definition of risk, i.e., they measure the uncertainty associated with the investment outcome. The measures are consistent with the view that security markets are efficient and always in equilibrium.

If one assumes the stock market is efficient and beating the market is largely a chance occurrence, then an appropriate interpretation of the performance statistics would contend that Fund X produced superior performance by maintaining a below average risk profile and dampening portfolio underperformance during the two negative market return years. Likewise, IFED-LG achieved superior performance by maintaining an above average risk profile and good fortune/luck produced strong alpha in three years.  

The two risk measures reported in Exhibit 2 are appropriate for performance evaluation if the probability of a fund producing positive alpha in a year is comparable to producing negative alpha i.e., the return distribution is symmetric. Investors that hold this view should follow a passive approach and avoid actively managed funds. Conversely, investors that deviate from this view should only select an actively managed fund after they have performed due diligence and become convinced that the fund follows a strategy that can capture abnormal returns i.e., the fund has a comparative advantage. Once an active approach is selected, the measures reported in Exhibit 2 become largely irrelevant in assessing performance.

How Should Standard Deviation and Tracking Error Be Used?

As noted above, the use of standard deviation and tracking error is conditional on the investment scenario. Two fundamental scenarios are outlined below.

Scenario 1: The investor believes security markets are efficient and opportunities to earn abnormal returns are limited. It then follows that the chances of a fund outperforming the benchmark mirror the chances of underperforming. The investor should adopt the first definition of risk, which is, “the uncertainty or volatility of an investment alternative” and implement a passive investment strategy. The investor should target funds with limited trading, such as index funds.

• In this scenario, standard deviation and tracking error are primary considerations in judging fund risk and performance. The two measures should be considered negative features of any fund considered by the investor. Funds with relatively high standard deviation and tracking error should be avoided.
  

• Fund X from Exhibits 1 and 2 is clearly the superior choice for the investor over IFED-LG. The low risk profile along with the above average returns make it the better choice. The superior alpha produced by IFED-LG is judged as resulting largely from chance. The relatively high standard deviation and tracking error make IFED-LG unacceptable.
  

Scenario 2: The investor believes that funds with superior strategies and/or managers offer opportunities to generate positive alpha. The investor should perform a thorough due diligence on alternative funds. The selected fund should present a convincing comparative advantage that justifies the creation of abnormal returns.

• Standard deviation and tracking error are irrelevant in judging fund risk and performance. The two measures, however, should be viewed as potentially attractive features of any fund considered by the investor as indications of the fund’s willingness and/or ability to deviate from average performance of passive strategies. Funds with relatively low standard deviation and tracking error should be avoided, such funds are “closet index funds” and are more appropriate as passive investments.  
  

• IFED-LG from Exhibits 1 and 2 is clearly the superior choice for the investor. The superior alpha produced by IFED-LG is attributed to the fund’s comparative advantage identified via the investor’s due diligence. This advantage was a primary consideration in selecting the fund. Fund X is largely a closet index fund that generated a small positive alpha by maintaining a low risk profile during a volatile market period.

In general, once an investor has made the decision to invest in an actively managed fund, standard deviation and tracking error become inappropriate measures of risk/performance. At that point, the measures become indicators of the degree of differentiation from the benchmark, nothing more.

How Should One Gauge the Risk of an Actively Managed Fund?

The decision to invest in an actively managed fund should follow a thorough due diligence process, which we touch on below. Once an investor has made that decision, the appropriate definition of risk is the second definition highlighted above. That is, risk is “the chance that the investment outcome will be lower than required or anticipated.” The appropriate risk measures for actively managed funds are downside risk measures, such as downside deviation.

Extending the above analysis, Exhibit 3 reports performance statistics for IFED-LG and Fund X. The exhibit includes downside deviation as a measure of downside risk. It also includes a performance measure that is adjusted for downside risk, the Sortino ratio. The major advantage of downside performance measures is that they do not penalize funds for producing unexpectedly strong positive performance. No active investor complains about their portfolio producing a return much larger than anticipated, so it is illogical to treat such returns as negative occurrences, which is what standard deviation and tracking error do.

Exhibit 3. Performance Statistics: 2017-2024

Unlike the traditional volatility measures, downside deviation is considerably lower for IFED-LG relative to Fund X. In addition, each active fund had a lower downside deviation compared to the S&P 500. IFED-LG’s return fell below the minimum acceptable return (MAR), which is assumed here as 5%, in two years (2018 and 2022), whereas Fund X fell short in only 2022.

Once returns are adjusted by the appropriate risk measure, the resulting Sortino ratio indicates that IFED-LG is superior to Fund X. The Sortino ratio penalizes the funds only for years where they fell short of producing the return necessary to meet fund obligations (in this case assumed to be 5% per year). The Sortino ratio indicates that both funds had superior performance relative to the S&P 500.

Active investors that chose Fund X or an S&P 500 index fund over IFED-LG based on risk considerations would have sacrificed considerable return over this period as shown in Exhibit 4.

Exhibit 4. Cumulative Performance, 2017-2024

Investors select actively managed funds with the expectation that the underlying investment strategy will yield above average gains. Both IFED-LG and Fund X produced such gains; however, the gains obtained from IFED-LG were superior and were generated by accepting less downside risk. That is, the additional gain was achieved with less shortfall risk. Over this eight-year period, investing in IFED-LG allowed an investor to generate a much higher return while limiting downside losses.

The IFED Strategy and Major Due Diligence Considerations

As noted above, the selection of an actively managed fund should follow a thorough due diligence process. There are several major criteria that should be considered in the process. Those criteria, and the status of the IFED portfolios with respect to each criterion, are detailed below.

Does the investment strategy have an underlying economic rationale that supports its success?

• The IFED strategy was designed based on over 30 years of academic research by EIA’s three founders. The founders published over 200 articles with over 10,000 citations and the findings from that research form the underpinnings of the IFED strategy. The strategy relies on extensive peer-reviewed research by the founders which shows that signaled shifts in Federal Reserve policy portend impending changes in market conditions, which are conducive to the success of firms with properly aligned features.

Does the investment strategy have a superior long-run performance track record?

• The IFED suite of tracked portfolios has produced significant positive alphas over the period from January 1999 through December 2024. This period witnessed a myriad of economic conditions including major economic upheavals e.g., a financial crisis, an inflation spike, and a pandemic, and thus, serves as an excellent proving ground for an investment strategy. See Exhibit 5 below for performance statistics for the IFED suite of non-customized portfolios.  

Exhibit 5. IFED Portfolio LT Performance and Performance Consistency, 1999–2024

Does the investment strategy have a live record of superior performance i.e., does it have proof-of-concept?

• EIA has launched two customized IFED indexes, Nasdaq IFED-L and Nasdaq IFED-LV, which apply the IFED strategy subject to specified constraints on holdings concentration. Nasdaq IFED-L is a large-cap US equity index and Nasdaq IFED-LV is a low volatility US equity index. The performance of each of these indexes is reported in Exhibit 6.

Exhibit 6. Nasdaq IFED-L & Nasdaq IFED-LV Live Performance, Launch thru 12/31/2024

The IFED strategy is grounded in economic principles and validated via academic research. The investment application of the strategy created IFED portfolios, which have produced superior long-term backtested performance, as well as superior live performance. In the past few years, EIA’s two live indexes have produced a compelling level of outperformance over a challenging market period that witnessed a pandemic, fears of inflation and a banking crisis, strong bull and bear market periods, and major shifts in both fiscal and monetary policy. Overall, these elements support the robustness of the IFED strategy as a viable investment approach.

Risk Statistics of IFED Portfolios

The IFED portfolios use 12 individual firm metrics to select stocks that are optimally aligned with market conditions. The portfolios are designed to prosper when normal return patterns prevail, while limiting underperformance when unusual factors drive returns. Thus, we anticipate the portfolios will produce periods of substantial outperformance, while also experiencing short periods of slight underperformance i.e., the return distribution will be positively skewed. Risk statistics and risk-adjusted performance measures for the IFED portfolios are reported in Exhibit 7.

Exhibit 7. Risk Statistics and Risk-Adjusted Performance Measures, 1999 – 2024 

EIA Uses Tracking Error to Generate Significant Positive Alphas

What type of team do you favor? At EIA, we designed an investment strategy that prospers (i.e., trounces the competition) when normal return patterns prevail while limiting underperformance when unusual factors drive returns. How is this accomplished? The IFED strategy shifts portfolio holdings to maintain an optimal match with prevailing market conditions. Further, the strategy favors stocks with quality metrics during each market environment.

Therefore, with respect to March Madness, at EIA we favor the team that has typically trounced its competition while avoiding big losses when things went poorly. We have a hard time understanding why maintaining close alignment with the competition (your benchmark) is a characteristic to be coveted.

While tracking error is typically considered a negative fund feature, the EIA team integrates tracking error into the IFED portfolios to produce significant outperformance. For example, in 2017 and 2022, the IFED strategy experienced tremendous tracking error because it produced extreme outperformance in periods of strong and weak market performance, respectively (see Exhibit 1). The IFED portfolios are designed to deliver substantial investment gains when normal risk factors dominate, while limiting underperformance when unusual factors drive returns.

Tracking error and standard deviation each reflect the level of uncertainty in an investment alternative and their value relies on the proposition that the outcomes are symmetrically distributed across both positive and negative outcomes. However, for active management to make sense, the underlying assumption must be that the strategy’s return distribution is tilted in the investor’s favor. The manager must offer convincing evidence that their investment strategy can tilt the outcomes in favor of investment wins over investment losses. We believe the economic foundation underlying the IFED strategy, along with the live record of outperformance support EIA’s success in this mission.