Low volatility does not mean low risk

Imagine being a trustee for a large public pension fund. The fund’s investment mandate says:

“The investment manager should utilise conservative investments intended to generate highly assured, lower‑volatility returns with long‑term stable and predictable cash flows.”

Now, suppose the portfolio has invested in a few wind farms. Is that the right kind of investment for this pension fund?

At first glance, wind farms seem to tick several boxes (alongside ESG considerations). First, a wind farm generates electricity that can be sold to power grids and large suppliers. That can mean “stable and predictable cash flows,” often linked to inflation. Second, unlike publicly traded shares, wind farms are not priced every second on a stock exchange, so their valuations can appear less volatile. Third, for these reasons, the investment’s returns may look less correlated with returns of mainstream financial assets.

But that is not what the North East Scotland Pension Fund (administered by Aberdeen City Council) says it experienced. The council is suing Federated Hermes, alleging the pension fund was placed into “high‑risk” investments that “no competent infrastructure manager” would have made.

Here is what has been reported about the case so far. In 2019, Hermes invested over £100 million in five Swedish wind farms (two operational and three in late‑stage construction). Instead of delivering steady cash flow with low volatility and low correlation to other assets, the wind farm investments reportedly lost more than 80% of their value.

More facts will likely emerge as the case continues. It appears the central issue may have been the long‑term electricity purchase agreements (power sales contracts) the wind farms entered into. These contracts sold electricity at a loss. In other words, the wind farms may have received regular payments, but the overall operation was not profitable. A revaluation of the wind farms was marked down sharply.

Worse still, it can be difficult to sell these kinds of assets quickly. Wind farms are typically illiquid: when something goes wrong, finding a buyer at a reasonable price may take a long time—or may not be possible at all.

This case is a useful reminder to be more critical of a few common messages—including ones often repeated by others.

• Volatility is often described as a “risk measure,” but volatility mainly measures how much prices move around. That can be useful when there are lots of frequent market prices to observe. For assets that are not regularly traded, valuations can look stable simply because they are only updated occasionally or rely on appraisal models. In other words, low measured volatility can sometimes reflect “smooth pricing,” not low risk.

• When considering alternative investments, always consider liquidity. If the investment goes wrong, the inability to sell can become a major part of the loss.

• It also highlights why both asset quality and operational quality matter. High‑quality infrastructure or real estate can generate strong cash flow, but only if it is run well. Poor operations can damage profitability, depress valuations, and make it harder to find a buyer.

The most important risk in any investment—public or private—is the risk of significant financial loss. Holding volatile investments can be stressful with some sleepless nights. But it could be worse to own a loss‑making investment that cannot be sold.

So don't just take the words from a product provider on an investment product. Understand the risks properly. If you are an individual investor, seek help from a financial adviser if needed. Or contact us (info@tricio-advisors.com) on risks relating to more complex products if you are a professional investor.   

James Chu CFA, Head of Investment Solutions