Dunatov: Volatility Measure ‘Dangerous’ for Long-Term Investors

(June 11, 2014) — Using volatility as a measure of risk for long-term investors is “potentially dangerous”, according to Coal Pension CIO Stefan Dunatov.

Writing in a new paper for investor supergroup The 300 Club, Dunatov argued that volatility was too short-term a metric to be an effective way of measuring risk for pension funds.

“The most confident analysts believe six months is a long time horizon for forecasting volatility, which is of limited use to a professional investor with a medium to long-term investment horizon,” Dunatov said.

“The increasing focus on forecasting risk, and the emergence of volatility as a popular measure of that risk, is a disappointing response by the investment industry to the recent difficulties it has faced.”

The financial crisis—“the single largest market panic since the 1930s”—coupled with falling interest rates and the move to marked-to-market liabilities has, Dunatov argued, increased a general feeling of uncertainty in the investment industry. This has in turn led to a desire to “define, measure and manage” risk.

“External advisers naturally prefer to work with an easily-definable measure that is common to many clients,” he said. “Their solution has been to replace the traditional focus on forecasting returns and all its difficulties with a short-term metric of volatility to forecast risk, which appears to be a more tractable measure.”

Dunatov added that not only was volatility an inappropriate risk measure, but it also highlighted a “lack of alignment of interests between the asset owners, consultants and asset managers”.

Instead of volatility, Dunatov argued that investors should look at a range of possible macroeconomic outcomes, “judging the likelihood of those outcomes occurring and choosing an asset allocation that best fulfils the investment objective within that context”.

He pointed out that each investor had a different set of objectives and the risks they faced should reflect this. In addition, Dunatov said volatility did not take into account the balance sheet risks faced by pension funds attempting to manage long-term liabilities.

There is still time to register to see Stefan Dunatov and nine other speakers push the boundaries of conventional investment wisdom at next week’s Summit of Dangerous Ideas in New York, hosted by aiCIO.

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