Get Sharpe and drawdown some volatility

THESE DAYS, if you consult a financial adviser, they will ask about your attitude to investment risk - low, medium, or high - before making any recommendations.

But risk is difficult to measure. Angela Knight, chief executive of the Association of Private Client Investment Managers and Stockbrokers (APCIMS), says : "A lot of research has been carried out on this subject. It shows a wide gap between how the man or woman in the street sees risk, and risk measures used by investment managers. There's a real problem about translating technical concepts into terms the consumer can understand.

"For most of us it probably means the chance of losing our original investment, or it's not keeping pace with inflation, or its value is fluctuating, or it not ultimately being worth enough to meet our goals.

"There's also a danger that investors will think index or tracker funds are risk free, by comparison to actively managed funds. In either case the absolute risk, that of losing all the money you first invested, is pretty small if you hold the investments long enough."

Now check on the past performance of unit or investment trusts, a PEP, or personal pension. You'll find it grouped in a class of like funds against which its past performance can be measured.

League tables in ads paid for by fund groups will only tell you how well they have done over the past few years - they don't tell they full story.

Specialist publications will also include a measure of "fund volatility". This is a one way of gauging risk. "Volatility" measures the upward and downward movements in the price of a fund in relation to it's average return. A fund which has above average volatility against its sector offers greater potential for gains and losses than funds with lower volatility.

If you pick up a specialist magazine, such as MoneyFacts, Life & Pensions or Money Management, you will notice that volatility is usually measured over 36 months. This is because it uses "standard deviation", which requires at least 36 observations to be meaningful.

Over the 36 months to mid-September, for example, the volatility rating of unit trusts in the UK Growth & Income sectors was 3.47. Over that same period, Global Emerging Markets' sector rating was 7.91, the FTSE 100 index had a rating of 3.64, while the broader FTSE All Share was rated at 3.44.

UK Growth & Income has 119 funds and their sector value grew by 43.44 per cent over the 36 months in question. The best performing fund is this sector, CF Utilities, returned pounds 1,766.97 for an investment of pounds 1,000, and had a rating of 3.49. Worst performer, Barclay's 500, returned just pounds 1,013.74 with a rating of 3.78.

What can be read into this when selecting a fund for investment? "Not much," according to Peter Jefferies, managing director of Standard and Poor's Fund Research, "unless you back it up with qualitative research, on how fund managers get their results."

Mr Jefferies says: "High volatility ratings are not in themselves a bad thing. They depend on the investment sector and asset class purchased. Timing is also important - investor's time horizons must match up to the volatility of the underlying investments they buy."

Some market analysts argue that a yardstick called "drawdown" is more useful than "standard deviation" measures of volatility. Drawdown measures the biggest price fall recorded over a 36-month period rather than average fluctuations.

It gives investors an idea of the most they stand to lose over a short period of time. But drawdown is only useful if the future resembles the past, which it often does not. "The problem," argues Mr Jefferies, "is that a market which hasn't moved against its trend will look riskier to a fund manager than one that has.

"It really doesn't matter whether prices are rising or falling, the longer they do, the greater the chance of a correction. Most investors only think about this once a market has been rising for a period - they invest too late, then when it falls they are tempted to sell."

There are other methods of analysing investment risk. The "Sharpe ratio", widely used in the USA, first deducts equity returns from those of a risk- free investment, then divides this net equity return by its volatility rating. Unfortunately, funds with both good and bad performance can display very similar Sharpe ratios.

"Beta analysis" measures fund volatility against sector average. A Beta of 1 shows that a fund moves exactly as its benchmark.

"The whole world wards a foolproof system of measuring risk," warns Mr Saunders, "but at best these are just rough guides."

The ultimate test for any investor is not just that of whether the fund is volatile, but whether that is the sector they want to be in. If it is emerging markets, then an average level of volatility is acceptable. Even so, it pays to ask any financial adviser what the volatility level of a fund they are recommending actually is - and why it is still worth investing in.