Thinking About Risk

We’ve all been covering recent ETF liquidity problems—but what about risk more generally?

Your blog, Jim, on the wide bid-offer spreads in certain areas of the European ETF market, has got me thinking more about risk, and how we should assess it as ETF investors. One of the risks that has come to the fore this year is liquidity risk—and recent events have shown that the liquidity of our ETF holdings can’t be taken for granted. As the old song goes (apologies for my musical taste), “You left me just when I needed you most.”

And, as you point out, Matt’s analysis in the July/August Journal of Indexes shows that there’s a big divergence across the US ETF industry, and the feature I posted a couple of days ago shows similar trends in Europe. The bid-offer spread (in percentage terms) on the least liquid Xetra ETF during Q3 was over 300 times that of the most liquid.

But, stepping back further and going to the textbooks on investment, it seems that a lot of what we’re taught on risk is fundamentally wrong.

For example, Investopedia tells us that risk is “the chance that an investment’s actual return will be different than expected … usually measured by calculating the standard deviation of the historical returns.”

There are so many false assumptions built into this definition that it’s difficult to know where to start.

First, using historical returns to measure risk is precisely what causes bubbles and busts in the first place. It’s not a coincidence that CDOs became popular in 2005, 2006, 2007, after decades-long increases in house prices. What could go wrong? No wonder this approach is called “driving at speed while looking in the rear-view mirror.” You’re guaranteed to crash – sooner or later. Yet we all do it.

Using the standard deviation of historical returns is, if anything, even more dangerous, because it gives a veneer of scientific respectability to the exercise. It’s now 45 years since Mandelbrot, the great mathematician, proved conclusively, by analysing cotton prices, that market returns do not follow a smooth bell-curve shape and are not independent of each other (thereby contradicting the basic assumptions of the normal distribution, which are needed to justify using the standard deviation as a risk measure in the first place). In reality price movements are far wilder, and they show some serial dependence (put simply, what happened yesterday can influence what happens today). But up to now Mandelbrot has been ignored, and models based on false assumptions continue to be used by banks, investors and regulators alike.

Plus, using the standard deviation as a risk measure assumes that markets are efficiently-priced, liquid and tradeable at all times, whereas we know that they are prone to jump around and leave big gaps on charts. Just look at the Volkswagen share price from two weeks ago.

None of this is necessarily bad news for us as ETF investors. In fact these observations probably reinforce the attractiveness of ETFs, simply because they imply that much of what is sold as management skill by hedge fund managers and other active investors is actually just luck. But you do need to be a lot more diversified than you think, and you need to accept that the unimagineable can sometimes happen.

Fortunately, ETFs have opened up large areas of the asset markets to retail investors at a competitive price, and enable us to trade them from the short side as well as the long side—which I think is a huge positive.

So, fundamentally, things are moving in the right direction. But a healthy understanding of risk can help us to survive—which is not a mean ambition in these turbulent times!

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