Understanding Volatility and Sharpe Ratio in Unit Trust Investing

Familiar with the following two jargon in unit trust investing?

You might come across the term 3-year 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 3-yr Annualised Volatility and a 3-yr 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 OSK-UOB KidSave Trust.

Calculating 1 yr Annualised Volatility for OSK-UOB 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 %
31-Jan-12	0.5645
29-Feb-12	0.5774	0.0129	2.29%
30-Mar-12	0.5464	-0.0310	-5.37%
30-Apr-12	0.5514	0.0050	0.92%
31-May-12	0.5457	-0.0057	-1.03%
29-Jun-12	0.5594	0.0137	2.51%
31-Jul-12	0.5614	0.0020	0.36%
30-Aug-12	0.5764	0.0150	2.67%
28-Sep-12	0.5840	0.0076	1.32%
30-Oct-12	0.5925	0.0085	1.46%
30-Nov-12	0.5940	0.0015	0.25%
31-Dec-12	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 OSK-UOB KidSave Trust)

What does 7.79% Annual Volatility means?

7.79% is the calculated deviation that can happen to the annual returns (%) of OSK-UOB 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 OSK-UOB Kid Save Trust to be 8.31% (refer to previous table). 

In terms of volatility, the 1 Year Return for OSK-UOB 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 Ex-Japan 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 Ex-Japan 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 risk-free rate describes the best available rate of return of a risk-free security. The interest rate of the 3-month US Treasury bill is often used as the risk-free rate but for us, using the Maybank’s 12-month Fixed Deposit rate of 3.15% as the risk-free 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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China Property Stocks Takes A Bashing!

I just read on Bloomberg news that China property stocks are taking a tumble due to an announcement by the China government on strict measures to curb property price from over inflating and minimizing property speculations. Here are the key measures:

1. An income tax as of 20% of the profit they make on the transaction. (previously home sellers can chose between paying 20% tax on profit or 1% - 3% tax on the selling price)
2. Potential home buyers who can't show proof of paying tax for at least one year will not be able to make a property purchase.
3. Down payment and mortgage rates on loans for second home buyers in cities will be raised.

The announcement caused a massive tumble on property related stocks both in China and Hong Kong today. The Shanghai Stock Exchange Property Index have already lost 9.25% as of writing.

How does that announcement impact us Malaysians?

Well from the perspective of Unit Trust investment, funds investing in China and Hong Kong properties will take quite a hit. Here are a few funds that will likely see a drop in it's NAV tomorrow:

1) Alliance Global Diversified Property Fund

5% of its NAV is invested in Hong Kong property company, Sun Hung Kai Properties Ltd. 

As of writing, Sun Hun Kai has shed 3.2% of it's price as shown below:

However due to this fund's globally diversified investment, the fund would not be heavily impacted by the announcement.

2) Hwang Global Property Fund

2.5% of its NAV is invested in Hong Kong Land Holdings Ltd which is currently trading in the Singapore Stock Exchange. It is expected that the stocks for this company will also decline when the market in Singapore opens tomorrow.

However due to this fund's globally diversified investment, the fund would not be heavily impacted by the announcement.

3) OSK-UOB Asian Real Estate Fund

This fund will be the hardest hit by the announcement. Just take a look at the fund's holdings:

What else is impacted?

Indirectly, shares in Australian mining companies will also see a drop. Once the tightening measures are in place, demand for property will drop causing a slow down in new properties development and ultimately reduce the import of raw construction materials by China from Australia. 

Summary

This is not a buy call for property related unit trust fund. In fact this is a warning to stay away from these funds. The price of these funds have dropped far below the listing price and will continue to drop even more. Until there is a turn around or a new policy change, property related unit trust funds will likely to remain in cold storage for quite some time.

Cheers and Happy Investing!

Investing In Yourself

How many of us here have fallen into scams and schemes that offer impossibly high returns? Or invest into unit trust based on the advice of a fellow friend or family that just started his/her part time unit trust career? How about rushing to make a buy at the stock market just because you heard a so called "insider" news from a friend? What about some of us whom are totally ignorant about investment, living in denial and believing that KWSP and fixed deposit savings is going to ensure your retirement?

Majority of us, at least at one point of our lives would have come across one of the situations above. The lucky one's actually made a profit while the majority end up losing their money. Temptation, impatience, "kiasu" and greed are the key driving emotions that cause many to lose their savings. Ignorance on the other hand makes us poor, requiring us to work for almost our entirely life to pay off debts and making ends meet.

While we throw a million excuses to our spouses, parent and family for our losses, our lack of money or how we end up in debt, the fact remains the same that we as human beings, blessed with a conscious mind have failed to utilized what's most precious to us! 

The author of "Rich Dad, Poor Dad" quoted in this in one of his books; 

"If you want to become rich and not be a victim of global changes, it is important that you develop the greatest lever of all: your mind. If you to be rich and keep your wealth, your mind - your financial education - is your greatest lever of all"

The greatest investment one can make above all is an investment into knowledge for our minds. Donald Trump, a successful businessman and real estate developer finds time to read in the wee hours of the morning all for the purpose of adding more knowledge.

The founding father of America, Benjamin Franklin once quoted;

"An investment in knowledge always pays the best interest"

How true indeed especially when you see influential and successful personalities (who have made more money then they ever could spend in a lifetime), are continuously adding more wealth for themselves. Wealth not in terms of $$$ but wealth of knowledge and wisdom!

Personally, I had my own share of losses in scams and get rich schemes during my younger years. I realized that if I've started my learning about personal finance and investing just a wee bit earlier, the possibility of falling into a scam would have been minimal. The Chinese have a saying that when you lose in gambling/investment, treat it as a tuition fee. Losing my hard earned money is an expensive tuition fee indeed, yet that experience taught me to become more financially savvy. Remember, when you "invest" without prior knowledge or know-how, that's called gambling. 

With the advent of the World Wide Web and Google, we are gifted with the opportunity to learn that our parents never had. By leveraging upon the many resources and tools available on the internet, you're now the master of your own knowledge gain.

I gained most of my knowledge from the internet, blogging, discussions and reading. Listening to the experiences of people in investing and personal finance is also an effective way for me to gain knowledge. The plus point is that I'm both inspired by success stories and cautioned by how other's failure. The one thing I have yet to grasp is the art of filtering valuable from trashy information.

It's never too late or too early for anyone to start taking control of their finances and ultimately their life. By reading this post, you've already taken the first step towards that goal.. All you need is a little grit and a whole lot of enthusiasm to make things work. Start now by making the best investment of all, an investment in knowledge!

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