A very important lesson we learn early on in our lives is the importance of saving and investing for our future. This should be a way to guarantee a good quality of life for our later years and even a good source of income and financial security.
Choosing in what to invest is a very important part of the process, because there is a wide variety of options for very different risk profiles. And as small investors, we face additional restrains.
These restrains could be related to the size of the capital we manage at the moment (which limits the portfolios we could have), the lack of financial knowledge and trading expertise, or simply the lack of time to actively manage an investment portfolio. But even with this restrictions there are some very good options available for us.
The first thing that comes to our minds could be the low-risk-low-reward certificates of deposit, but given the current situation with low money market rates, this option seems unattractive . Other option could be collective investment funds (CIF), where you have a small stake on a big fund that can manage very diversified portfolios, that you by your own could not. Or may be you could even buy ETFs, that replicate the performance of a stock index such as the S&P 500.
In this document we will see a comparison between the collective investment funds for the Colombian market (where I am from), and how they compare with a couple of ETFs.
2. Collective Investment Funds
Because I live in Colombia, I searched for the CIFs available here. The information of this industry is compiled by the Asociación de Fiduciarias de Colombia (AFC), which also defines the characteristics of the different categories of funds.
The CIF industry offers a wide variety of funds, each one intended for a specific risk profile. This will determine the composition of the portfolios of the CIF, and the assets they are willing to invest in. This information is very important to consider as you search for options.
For this analysis, I only considered the daily average year return and volatility of each category registered in the AFC for the period 2017–2020, and found the following results:
This table show a wide variety of returns and volatility for the different categories of funds, which had an average year return from almost 7% for the “Fondo Accionario Internacional” (which invest in international stocks), to -4.1% for the “Fondo Balanceado Mayor Riesgo”.
A very important thing to notice here, is the huge variability in the different average year volatility that each category of fund was subject to, showing the wide range of options you have for this kind of investment.
When thinking about these results, you must have in mind that the very volatile year 2020 was considered in the analysis, which can explain some of the most volatile fund averages.
This point can be seen clearly in the this graph:
Here we can see the huge impact that the COVID-19 pandemic had over the best performing CIF category, both in the returns and in the volatility. The graph and table above tells us another important lesson: even though all assets are subject to the same shocks, depending on the assets managed the impact could be very different (as seen by the different volatility measures among the funds’ categories).
3. Exchanges Traded Funds (ETFs)
For the ETF part of the analysis I analyzed the SPY and GXG ETFs. The SPY replicates the performance of the S&P 500 stock index and the GXG replicates the MSCI All Colombia Select 25/50 Index.
When seeing the daily behavior of the returns and volatility we can see again a huge variability of both returns and volatility, with a sharp increase of volatility around the pandemic. This shows that ETFs are also very vulnerable to the swings caused by economic and financial phenomena.
Another important point is to see the difference between these two ETFs, both in terms of return and volatility. This is also important to understand: the ETFs also present a very distinct behavior, thus, if you choose this alternative, you will need to search for an ETF that matches your risk profile and investment preferences.
4. Which option is better?
Now that we have seen some important insights about both the CIFs and the ETFs, we will compare them. To do this I used a metric known as return on risk:
This metric captures in just one number the performance of the different investment options, accounting for both return and risk. As you can see, the higher the RoR the better. It has a direct relation with return and an inverse relation with volatility. This means that more return and less volatility are desirable.
As you can see in the graph above, there is not a significant difference between the RoR of the ETFs and the CIFs. Even though the SPY ETF is one of the better investment options (according to the RoR metric), it is not an outstanding option, and there are some CIFs that outperform it. And the GXF EFT is outright mediocre.
This means that, when searching for an investment option, you cannot choose only by the asset type (CIF vs ETF), but look more closely to the individual performance of the assets/portfolios. This results should be taken in the context of each individual investor’s risk apetite, and the markets/instruments they want to invest in.
5. Returns and Volatility
An extended mantra in the financial world is that the higher the reward you seek, the higher the risk you should accept. Thus, one should expect a clear relation between long-term returns and long-term risk. And with this metrics in mind take a better decision when deciding in which product to invest.
Along this analysis I have been using volatility as a proxy of risk. This is a widely used measure of risk, but it is very debatable how good it is. As a final exercise I tried to see how good is the volatility as predictor of return.
The plot above shows the 4-year average of both year volatility and return for all the different CIFs in the analysis. At first sight, it seems like there is not a strong relation between both variables.
This was confirmed after performing a linear regression using the volatility as predictive variable and the return as the objective variable, which only yielded an R-squared of around 0.01 for both the training and test sets.
This means that volatility seems to not be a good proxy of risk. Thus, if you want to do a return-risk analysis you should broaden the perspective and analyze the assets that compose the different portfolios, other risk metrics and may be some behavioral aspects of finance.
But the first point stands: investors should have a return (risk) target, and then minimize (maximize) risk (return). Thus, the metric used to measure risk should be chosen carefully.
Small investors have a wide variety of investment options at their disposal, even though they face additional restrains. Two good options are CIFs and ETFs, that are easy to invest in and manage. And as we saw, there are not significant differences between them in terms of RoR.
When searching for an investment option, the investor should not only compare by return, the risk factor is also fundamental. Thus, the investor should have a clear risk profile, and then search for a suited portfolio or investment vehicle that adjusts to it.
Finally, when analyzing risk, it is important to understand that there is not a perfect one number risk measure. Even though the volatility is a widely used measure of risk, we have seen that it seems to not work well. Thus, the investor should broaden his/her perspective and look for the details of the composition of the different options, maximizing (minimizing) returns (risk).