Holding Period as a Consideration With Regards To Common Risk Metrics

There is something about the nature of stock markets that attract speculators and traders who do not care about intrinsic value as opposed to investors who do. Correspondingly, much of risk management has focused on short-term volatility that cater to those security slingers. Standard Deviation has become the de facto number to brag about or manage around. Somehow, somewhere along the line, most investors have been brainwashed to believe a low Standard Deviation is as valuable as a high absolute return.

Pzena Investment Management, a respected shop adhering to a classic value-oriented approach, who put the theory through the wringer (http://www.pzena.com/investment-analysis-3q14-2). Unsurprisingly, they found: “Much of the daily or monthly volatility of a portfolio disappears as the vagaries of short term price movements offset each other in the long term and the frequency of loss decreases substantially.”  In other words, Standard Deviation draws an inaccurate picture for long-term investors when focused on daily or monthly timeframes. Zoom out, and what do we find?

On a month-to-month basis, stocks fluctuate, and for the S&P 500, 40% of the time, it will be lower than it was the previous month. But by zooming out, five-year periods exhibit less relative fluctuation and less loss. The trend of lower volatility and shrinking losses is even more pronounced for ten-year periods.

Okay, great, so we know stocks go up in the long term. Not exactly breaking news. But... why don’t most hedge funds seem to know this?

Here, most hedge funds, although they have a lower monthly Standard Deviation than World Equities (stocks), actually have a higher five year Standard Deviation.

And the kicker is they do not have definitively superior performance over the long term! Stocks generally go up in the long-term. Hedge funds? Not as certain.

The explanation is that most active funds cannot help but micro-manage their short-term volatility. Those Masters of the Universe sell themselves by touting an ability to achieve equity-like returns without equity-like risks. In the short-term, they can make a case for being successful. But longer term, it is a miserable strategy that offers subpar returns with higher risks.

Moreover, it is nonsensical. Equities are, almost by definition, a long duration asset class. Managing short-term volatility for an asset intended as long duration is like zig-zagging a ship across the ocean in a vain attempt to avoid waves. It’ll take twice as long to get to your destination and there is simply no way to guarantee there will be no waves along the way.