It is widely assumed that when two funds have similar returns and are equivalent in all other respects (e.g., exposure to event risk, quality of personnel and operations, etc.), the fund with lower volatility is the better investment. On the face of it, the assumption that higher volatility is a negative attribute certainly seems reasonable. Although this assumption is true in most circumstances, its actual validity is dependent on a factor that is often overlooked. Sometimes, higher volatility doesn’t matter or can even be beneficial.
On one occasion, I went to interview managers of a fund that was located in an off-the-beaten-path location. After I was done, I went to visit a fund of funds manager I knew who was located in the same region. At one point, our conversation turned to the fund I had just visited. I naturally assumed he knew the fund since there were few hedge funds in the area. It turned out that he not only knew the fund, but had worked with one of the managers for 12 years at another firm. His comments about the manager were favorable.
“Are you invested in his fund?” I asked.
“No,” he replied.
“Can I ask why not?”
“Well, they have a Sharpe ratio of only about 0.4,” he replied.
“I know,” I said, “but that is because they have high volatility and since they are inversely correlated to everything else, high volatility is not a relevant factor. In fact, for an inversely correlated fund, high volatility may actually be beneficial. ...