In times of uncertainty, when volatility abounds, an understanding of risk is essential equipment in the hunt for returns, says Tony Doherty
The inappropriate pricing of the credit risk of securitised mortgage investments has arguably been the key catalyst of the current macroeconomic downturn, so it has never been more important for investors to have a sound approach to appraising investment risk.
Over recent months there has been anecdotal evidence of a number of heavily discounted secondary market deals on indirect property funds which have appeared attractive at face value but which have become significantly less so as the market correction has ensued. A mispricing of risk for these investments and an over-emphasis on potential returns could be one of the reasons why some investors appear to have overpaid.
In uncertain times such as these an alternative approach which focuses on a target information ratio and not just a target rate of return could be more appropriate.Our multi-manager team has continued to develop a risk-adjusted investment process to the acquisition appraisal of indirect units.
The overriding principle of this approach is to take into account in equal measure the potential total return of the proposed investment as well as its potential performance volatility. In essence, for relative return mandates this requires an adjustment to the target rate of return of an investment to reflect its expected tracking error.
However, before the mechanics of such an approach are explored further, an important question needs to be asked: Is there any evidence to show that a significant relationship between risk (measured in this case by tracking error) and return has actually existed for unlisted UK property funds? The answer is important, as if no relationship is demonstrable then any process which attempts to adjust the required rate of return for an investment opportunity according to its expected tracking error becomes arbitrary.
Have UK property fund investors been rewarded for risk? To tackle this question we have compared the total returns relative to benchmark and the actual tracking errors of all funds in the IPD UK Pooled Property Fund Index from their inception dates, excluding those with a track record of less than five years (see figure 1). The results support the view that there is a trade-off between higher risk, as measured by tracking error, and higher returns.
Drilling down further we find that the relationship between tracking error and excess return has tended to be strong for the sector specialist ‘value added' funds whereas it has actually been weak for the diversified, balanced funds (‘core' funds).
Intuitively this makes sense as in the long run we would expect sector specialist value add funds to provide investors with greater excess performance per unit of risk than their balanced core counterparts. This is because they tend to employ asset managers who are specialists in their particular fields and operate fee mechanisms which specifically incentivise outperformance. In addition, these types of funds have tended to utilise a more active approach to gearing as a means of enhancing total returns than their balanced core counterparts.
So what are the implications of these findings for portfolio construction? Investors looking to construct a portfolio of property funds to outperform a peer group benchmark may maximise their potential risk-adjusted return more effectively by using balanced ‘core' funds primarily to reduce the risk of portfolio underperformance (ie, to decrease the tracking error). Consequently they should favour those core funds at the lower end of the risk curve as there is little evidence to suggest that those balanced core funds at the higher end of the curve provide better performance.
In contrast, this subsequent ‘risk budget' saving of investing in low tracking error core funds may then be better allocated to sector specialist value add funds where the evidence suggests that investors have tended to be rewarded for moving up the risk curve.
So once an investor has decided on the preferred constituents of their portfolio, what prices should they pay? To answer this we have looked towards an information ratio-based solution, in other words the ratio of expected return to risk, rather than just relying on a target rate of return.This approach is beneficial for portfolio construction as it helps to differentiate between managers that may well provide strong relative returns but take excess risk to do so, and other managers that may not provide the same magnitude of outperformance but may well take significantly less risk in achieving them.
The process can be split into three steps. Step 1 is to decide upon a target information ratio. This is done by using what we have now demonstrated as the market risk/return line (figure 1). Step 2 requires the relative return of a fund and its potential tracking error to be forecast. Forecasting the tracking error is arguably more difficult than forecasting the relative return. We have therefore created a proprietary risk assessment model called Quantum to do this.
Quantum evaluates risk through an appraisal of a number of fund characteristics including structure (sector positions), stock (assets, development exposure and yield analysis), and fund gearing. A combination of the two variables produces a forecast information ratio for the investment (figure 2).
Step 3 is to determine the fair price of a potential investment. This can now be derived as the discount/premia which would be required to move the projected information ratio of the investment to its target. Bear in mind that the excess returns and tracking errors in figure 3 are annualised and so the adjustments indicated by the arrows would need to be multiplied for each year of the investment horizon - three years in this example.
In practice such an approach helps to ensure that in cases where two funds look to be offering similar potential total returns (eg, funds such as fund A and fund B) but significantly different potential volatility, investors do not make the mistake of offering the same discount for each.
An increase in the emphasis placed on the risk inherent in an investment and a sound quantitative risk-adjusted approach to investment appraisal are essential components in any investor's toolkit. This is particularly so in today's volatile and uncertain market. However, where there is volatility there is also opportunity. And as the cycle begins to turn it will be those who can most accurately price in risk that will exploit these opportunities most successfully
Tony Doherty is property fund manager, Schroders