You might come across the term 3year Fund Volatility at the top of any fund factsheet. Here's a sample from AMB Dividend Fund factsheet:
*Note : 3 Year Fund Volatility and 3 Year Annualised Volatility are the same.
So what exactly is a 3yr Annualised Volatility and a 3yr Sharpe ratio?
What is Volatility?
Volatility in term of unit trust is a measure of how much the price of a fund fluctuate (go up and down) during a certain period of time.
What is Annualised Volatility?
Annualised volatility is the measure of a unit trust price fluctuation over a period of one year.
What is 3 yr Annualised Volatility?
Measure of price fluctuation of a unit trust price over a period of 3 years.
How to calculate a 3 yr Annualised Volatility?
Normally the 3 yr Annualised Volatility of a fund is already calculated and made available for investors. However, it is important for investor to understand how the 3 yr Annualised Volatility is derived. To make things easier, I will demonstrate how a 1 yr Annualised Volatility is calculated for OSKUOB KidSave Trust.
Calculating 1 yr Annualised Volatility for OSKUOB KidSave Trust:
1) First step is to derive the monthly volatility for a 1 year period. In order to do this, we will need the unit trust price for every month end over a period of one year (from Jan 2012  Dec 2012). Using the monthly unit trust prices, we are able to calculate the monthly % returns as shown in the table below:
Date

Monthly NAV

Difference between NAV (month to month)

Monthly Returns in %

31Jan12

0.5645


29Feb12

0.5774

0.0129

2.29%

30Mar12

0.5464

0.0310

5.37%

30Apr12

0.5514

0.0050

0.92%

31May12

0.5457

0.0057

1.03%

29Jun12

0.5594

0.0137

2.51%

31Jul12

0.5614

0.0020

0.36%

30Aug12

0.5764

0.0150

2.67%

28Sep12

0.5840

0.0076

1.32%

30Oct12

0.5925

0.0085

1.46%

30Nov12

0.5940

0.0015

0.25%

31Dec12

0.6114

0.0174

2.93%

*Average Monthly Returns
over 1 year

0.69%


**1 Year Return in %

8.31%


* Calculated by summing
up all 12 month's monthly returns and dividing the total by 12


* * Calculated by taking
the Monthly NAV on 31 Dec 12 minus NAV on 31 Jan 12. The difference is
divided by NAV on 31 Jan 12 after which the result is converted to %

2) From the table above, we are also able to determine:
 Average Monthly Returns over 1 year : 0.69%
 1 Year Return in % : 8.31%
3) To calculate the monthly volatility, all we need to do is plug in the information from Item 1 and Item 2 into the formula:
where:
 x : Monthly Returns in % from Jan 2012 till Dec 2012
 Ma : Average Monthly Returns over 1 year (0.69%)
 n : 12 (months)
4) The formula for monthly volatility would look something like this:
________________________________________________
σ_{monthly volatility } = /(2.29%  0.69%)^{2} + (5.37% 
0.69%)^{2} +…..+ (2.93%  0.69)^{ 2}
/ 
√ (12 – 1)
=
2.25% (monthly volatility)
5) Once we have obtained the monthly volatility, we can now derived the 1 year annual volatility:
__
σ_{annual volatility } = σ_{monthly
volatility } X √12
= 2.25% X 3.464
= 7.79% (1 year annual volatility for OSKUOB KidSave Trust)
What does 7.79% Annual Volatility means?
7.79% is the calculated deviation that can happen to the annual returns (%) of OSKUOB Kid Save Trust Fund over a period of 1 year. This deviation occurs 68.27% of the time*.
*(68.27% is an empirical fixed figure for deviation)
Earlier we calculated the 1 Year Return for OSKUOB Kid Save Trust to be 8.31% (refer to previous table).
In terms of volatility, the 1 Year Return for OSKUOB Kid Save Trust will deviate between 0.52% (8.31%  7.79%) to 16.1% (8.41% + 7.79%) at 68.27% of the time.
The actual 3 year Annualized Volatility is calculated in the same manner except that daily prices instead of monthly prices will be used for the calculation. The period for calculation is 3 years instead of 1 year.
I still do not understand how the Annual Volatility Calculation is Done!
Worry not as we do not need to understand the mathematical part of it. What's most important when you see Annual Volatility (3 year Annualized Volatility), you should be aware that:
 The higher the volatility figure, the more volatile the fund is.
 The lower the volatility figure, the lesser volatile the fund is.
 When comparing between two funds of the same category, the fund with the lower volatility will have lesser fluctuation on the unit price over a period of time.
Say two funds with the same 3 years Annualized Returns are compared in the table below:
Eastspring Investments
Asia Pacific Equity MY Fund

Pheim Asia ExJapan
Islamic


3 Year Annualised Returns

2.20%

2.10%

3 yr Annualised
Volatility

18.16%

16.48%

Both funds have almost similar annual returns of 2.10%  2.20%. In terms of volatility, Pheim Asia ExJapan Islamic fund has a lower percentage as compared to Eastspring Investment Asia Pacific Equity MY Fund. While both funds are able to produce the same returns, PAEJI's fund manager is better in managing and preventing the fund price from over fluctuating!
Knowing the volatility of a unit trust fund only allows an investor to know the range of returns of that fund, it does not reflect the strength of the unit trust performance. This is where the Sharpe Ratio comes into play!
What is Sharpe Ratio?
The Sharpe ratio indicates the excess return an investor is expected to receive for every unit of risk that the unit trust undertakes.
The formula for calculating Sharpe Ratio as shown below:
Referring to the definition above, the aspect of risk and returns are the main key points here. Sharpe Ratio provides an indicator on your returns versus the risk you have taken to invest in that unit trust.
Looking at the formula once again, you can see the "Annualised Return" is the profit you expect to make. "Annualised Volatility" is the amount of risk you are taking. When dividing profit with risk, you get a profit vs risk ratio.
What about the term Risk Free Rate?
The riskfree rate describes the best available rate of return of a riskfree security. The interest rate of the 3month US Treasury bill is often used as the riskfree rate but for us, using the Maybank’s 12month Fixed Deposit rate of 3.15% as the riskfree rate is good enough.
By deducting the risk free rate from the annualised return, we now have the 'true' returns of investing in unit trust. Dividing the 'true' returns with the annualised volatility (risk taken), we have what we call the Sharpe Ratio!
It's example time!
Kenanga Growth Fund

AMB Dividend Fund


3 Year Annualized Returns

20.80%

16.00%

3 yr Annualised
Volatility

9.48%

8.01%

Sharpe Ratio

1.79

1.6

Here's a compariosn between 2 Malaysian Equity Unit Trust Fund. Kenanga Growth fund has a better 3 year annualized return albeit with higher Sharpe Ratio. AMB Dividend Fund generates a lower return and is reflected by the low Sharpe Ratio and lower volatility. Hence the saying "High risk, high returns"
Summary
Understanding about Annualised Volatility and Sharpe Ratio adds another layer of precaution when it come to investing in unit trust. In my opinion, the best time to utilize Annualised Volatility and Sharpe Ratio is when faced with the dilemma of choosing between a few funds with the same annual returns. Go for the lowest percentage volatility and the highest sharpe ratio if possible!
Cheers and Happy Investing!
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Hi,
ReplyDeleteA good read, thanks. Seek your opinion, is taking personal loan to invest in unit trust, a good choice? Compared to ASB where at least we can finance the loan with the stable yrly dividend, how about unit trust?
Hi Firdaus, it is highly not advisable to take a loan to invest into unit trust.
ReplyDeleteLike the explanation, good journey through the figures and how the build on each other.
ReplyDeleteIs it that both Fundsupermart and eUnittrust provide Votatility and Sharpe ratio?
ReplyDelete