Fund managers are judged on whether their return beat benchmarks, which are the industry or the stock market average returns. But beating the average was not enough; it was possible to outperform in the short term, simply by taking a lot of risk.
Every investor knows that high volatility associated with an investment is a bad thing. The more an investment’s returns fluctuate from month to month, the greater its volatility, the riskier the security is. Big fluctuations also suggest fear, because they mean that investors are frantically changing their minds about what stocks are worth in the face of great uncertainty. On this ground, the CBOE volatility index, also known as VIX, is often referred to as the "fear index”.
Efforts to spot excessive risk taking to achieve extra ordinary returns led to the widespread use of the Sharpe ratio as a measurement tool for managers’ performance. The Sharpe ratio, devised by a Nobel-prize winning economist, looks at the relationship between investment returns and their variability. The higher the ratio, the more reward there is for a given amount of risk.
Greedy investor who is eager to win extraordinary gains will take excessive risk, which often means tremendous volatility.
A manager who earns a relatively modest return with very low volatility usually attracts more investors. Indeed, that was an important part of the appeal of the hedge-fund industry; it often did not match the stock market in the bull years but made up for it by outperforming during bear markets. Low volatility was a large part of Bernard Madoff’s appeal. He offered smooth returns, such a contrast with the violent swings of the stock market.
Low volatility doesn't always mean good though. It has some significant drawbacks.
A focus on low volatility makes little sense for investors having very long term investment horizon such as a pension fund or college endowment. But it may be hard for investors to recognize the difference between a fund manager who is able to produce a high, but volatile, long-term return and one who is simply erratic and incompetent. It forces manager to pay more attention to short term results.
Illiquid assets may contribute to the low volatility, because such assets are traded rarely, they change price rarely as well. Property and private equity can fall into this category. The returns may look smooth but this is an illusion.
A manager might have adopted a “picking up nickels in front of steamrollers” strategy with lots of small gains but the occasional big loss. The manager, for example, could be selling put option against a big stock market fall. Such falls do not happen most of the time and the manager keeps the premium. But when the market tumbles, the manager, as a seller, may have to pay out a sum of money that could be much larger that his previous gains. The more sophisticated the fund manager appears to be, and the more complex his model, the harder it is for the client to tell whether the strategy will produce skewed returns. Its performance was brilliant, until it crashed.
Managers may be tempted to resort to fraud in order to maintain smooth returns, or low volatility, when things go wrong. Charles Mulford and Eugene Comiskey, two professors of the Georgia Institute of Technology, found that three of the main motivations for “creative accounting” were to reduce the volatility of earnings to help the company meet forecasts and boost the share price. Another example of fraudulent investment is a giant Ponzi scheme ran by Madoff. The returns achieved by Madoff’s hedge fund were too good and suspiciously smooth.