Financial Daily from THE HINDU group of publications
Monday, Apr 19, 2004
Columns - Mark To Market
Volatility rating Usefulness depends on fund's investment style
A high-grade volatility rating essentially means that the fund's returns volatility is low. A risk-averse investor may prefer a fund that has a high-grade volatility rating while a risk-seeking investor may prefer one with a low rating.
The usefulness of the rating, however, depends on the consistency in a fund's investment style. Besides, the volatility rating has to be read in the context of asset price behaviour.
Asset price volatility varies with time. Using a single measure to compute volatility over an extended time frame may not capture the "true" asset price behaviour. Despite these shortcomings, volatility rating may be useful. Investors, after all, need a reference point to compare peer funds on returns and volatility.
Fund style: In India, few funds follow a consistent investment style. That could hamper the usefulness of volatility ratings. Here is why. Take a diversified equity fund. Suppose the portfolio manager had a large-cap growth bias in the last two years but now shifts to mid-caps.
The nature of volatility in the current period based on the mid-cap bias may be quite different from the volatility during the period when the fund had a large-cap bias. Providing a volatility rating under such circumstances may not help the investors, especially if the style cycle itself varies.
That the rating agencies may continually monitor the fund for rating changes is no consolation. The investment decision based on the volatility rating may have been made by then. Perhaps, style benchmarks should be created first. This would help investors gauge the consistency of investment style. Volatility rating along with the tracking error to the style benchmark may be more meaningful for making investment decisions.
Bond funds: One argument could be that investment styles may not be of much importance in the bond market. And rating agencies are more likely to provide volatility rating for bond funds than for equity funds. The argument is true to a certain extent.
A typical bond fund portfolio is constructed based on the portfolio manager's view of the interest rates. If the portfolio manager expects the rates to move up, she may load the portfolio with short-term bonds. If she expects rates to decline, long-term bonds will be preferred choice. At other times, based on the risk preferences of the portfolio manager, the fund may be invested across the yield curve.
If we were to assume that interest rate changes are random, a volatility rating based on the NAV over a longer time horizon may, perhaps, be useful to the investors.
Yet, one problem remains. The yield curve in India is still not well defined. The prices are primarily determined by the short-term demand and supply for bonds. Besides, not all bonds are regularly traded. The price change is not, therefore, continuous.
A volatility measure based on such discrete price jumps may sometimes be misleading. This problem is even more for corporate bonds, as they are hardly traded.
Asset price cycles: Asset price volatility varies with time. This behaviour needs to be captured in a rating model. Typically, GARCH (generalised autoregressive conditionally heteroskedastic) models capture such time-varying volatility. Essentially, a GARCH model is constructed so that the volatility in one period is dependent on the volatility in the previous period.
But GARCH models are dependent on dataset used- in this case, the fund's net asset value. A change in the sample period could well change the model output. In other words, the output from a GARCH model may not be robust.
It is, therefore, highly unlikely that rating agencies would want to use such complex and academic models to capture "true volatility".
Using a standard-deviation-like measure to capture the time-varying volatility, on the other hand, has its problems.
Investment decision: Despite these shortcomings, volatility ratings may be of use to the investors. Such a rating could provide some reference point for investors to make their investment decision. Rating agencies would do well to state the changes in investment style along with the volatility ratings.
This could help the investors read the ratings in the context of the change in fund style. In any case, the mutual fund industry is fast maturing. It is only time before we have style benchmarks and a well-defined yield curve. Volatility rating may be more helpful to investors then.
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