In general, the higher the volatility, the higher the potential for future returns over the long term. There’s also a higher potential for loss of course, but in almost all cases the best-performing open and closed-ended funds over 10, 20 and 30 years are those with a high annualised volatility.
The interactive scatter graph feature on FE Analytics illustrates this point very nicely. The x-axis measures volatility while the y-axis measures total return, enabling investors to compare funds on a risk-adjusted return basis.
Those in the top right of the graph are those that have performed strongly though with a high volatility, whereas those in the bottom left are low-risk funds that have eked out a small return. The graph below shows the return and volatility of every single IA sector over the past decade, and there’s clearly a direct relationship between risk and return.
The top right corner is packed with sectors operating in riskier asset classes, namely emerging markets and smaller companies. The bottom right consists of cash, mixed-asset and fixed interest sectors – as you might expect – whilst developed market equities sit somewhere in the middle in both cases.
Risk-adjusted performance of IA sectors over 10yrs
Source: FE Analytics
The great thing about investment, of course, is that not everything follows the trend. While there is a definite relationship between risk and return, some sectors have little to show for their high levels of volatility, while others have given investors the best of both worlds.
Two bond sectors – IA UK Index-Linked Gilt and Global Emerging Market Bond – are standout performers in the 10 years to 1 January 2015. As well as being among the 15 least volatile sectors, they have managed returns of over 100 per cent, putting them ahead of much higher risk sectors including IA Flexible Investment and IA UK Equity Income.
And on the negative side? Yep, you guessed it – IA Japan and Japanese Smaller Companies have been the worst from a risk-adjusted return basis, delivering less than 50 per cent returns with an annualised volatility between 15 and 17.5 per cent. This compares to just 7.74 per cent volatility for IA UK Index-Linked Gilt.
Looking at individual funds is even more interesting, revealing a number of high profile anomalies.
Risk-adjusted performance of IA funds over 10yrs
Source: FE Analytics
The funds that straight away jump out are the three isolated ones on the left hand side of the main grouping. Nigel Ashfield’s Freehold Income Authorised fund has returned a healthy 92.81 per cent over the past decade – a touch more than the FTSE All Share – with an annualised volatility of just 1.21 per cent. This figure has only beaten by a handful of cash funds.
How has Ashfield done it? The fund invests in many thousands of ground rents, which have enabled it to generate a yield of 4 per cent per annum with next to no drawdown. The big risk when investing in this fund is liquidity, or the lack thereof, which is difficult to express in graph format. It’s for this reason that Freehold Income Authorised can only be purchased by investors who have a financial adviser.
Performance of funds and index over 10yrs
Source: FE Analytics
The other two funds are more traditional, though far from popular with investors and advisers. CF Ruffer European sits in the Mixed Investment 40-85% sector and invests in a mixture of UK and continental European equities and bonds and cash.
Managers Timothy Youngman and Guy Thornewill have kept downside losses to a minimum by tactically using cash and bonds when they see storm clouds on the horizon. They made money in 2008 even though their sector average was down more than 20 per cent, for example, but have also consistently made double-digit returns on the upside.
The fund has one of the lowest volatility scores of its kind over the decade and is also by far the best performer, with returns of over 220 per cent.
The little-known CF Buxton fund is another multi-asset fund, investing in equities, bonds, cash and alternatives such as structured products. Unfortunately it’s not available to retail investors.
Healthcare funds run by Schroders, Fidelity and L&G have performed very strongly as a group. Healthcare is traditionally seen as a defensive sector, but ultra-low valuations in the mid-2000s and the rapid growth of biotech in particular have led to stellar returns as well.
Elsewhere, high profile managers that are well-known for delivering above average returns with below average volatility dominate. At the higher return scale, First State is the standout group.
First State Greater China Growth, Asia Pacific, Asia Pacific Leaders, Global Emerging Markets and Emerging Markets Leaders are all among the top-10 best performing funds of the last decade, returning between 290 and 350 per cent.
While the asset classes they focus on ensure they aren’t low-risk, they are significantly less volatile than their peers. First State Asia Pacific Leaders, for example, is less volatile than a number of UK Equity Income funds.
Performance of funds and index over 10yrs
Source: FE Analytics
In developed markets, the Invesco Perpetual UK equity income team reign supreme. Invesco Perpetual Income, High Income and UK Strategic Income have thrashed the FTSE All Share and their peers over the past decade with returns of over 170 per cent, but have at the same time consistently outperformed during down markets.
Income and High Income were formerly run by Neil Woodford but taken over by Mark Barnett (pictured) last year. Barnett has run UK Strategic Income since 2006. Both are naturally cautious investors, preferring to hold high quality companies in traditionally defensive sectors such as healthcare and tobacco. Their emphasis on sustainable dividend payers has helped them compound returns over the long term, but also smooth out the ride.
Richard Woolnough’s M&G Strategic Corporate Bond portfolio has been one of the least volatile funds of the last decade but has still almost doubled investors’ money over the period. The fund sits in IA Sterling Corporate Bond and has benefitted from the rallying bond market, as well as Woolnough’s strong stock picking.
Other funds that deserve a mention include Veritas Global Focus, Liontrust UK Smaller Companies, CF Ruffer Total Return, Trojan Income, Majedie UK Focus and Ecclesiastical Higher Income.
Unsurprisingly, many of the funds mentioned here score very highly for Sharpe ratio, which is one of the most popular measures of risk-adjusted return. The ratio measures a fund's return relative to a notional risk-free investment – in this case, cash. The difference in returns is then divided by the fund's volatility.
In simple terms this highlights the funds that have the best balance of risk and returns. Excluding cash and short-dated specialist bond funds, Freehold Authorised Income tops the list with a score of 3.29, followed by M&G Strategic Corporate Bond with 1.49 and CF Buxton with 1.48. CF Ruffer European also made the top-10.
One fund that has a very healthy Sharpe ratio – 0.79 – but has yet to be highlighted is AXA Framlington Biotech. It has an annualised volatility of 20 per cent over the last 10 years, but returns of 341.06 per cent have more than compensated for this. The likes of Fidelity China Focus, Fidelity South East Asia, Skagen Kon Tiki and JPM India have similar risk profiles.
Unfortunately the same can’t be said of some of the most volatile funds over the period.
Risk-adjusted return of IA funds over 10yrs
Source: FE Analytics
Gold equity funds are among the worst offenders. In spite of fantastic performance in 2009 and 2010, a dreadful 2012 and 2013 in particular has seen this highly volatile asset class post disappointing returns over the past decade.
The fund that lurks in the bottom right hand corner of the chart has earned the unfortunate accolade of being the most volatile and the worst performer. CF Ruffer Baker Steel Gold, which has a small-cap bias, has lost more than 25 per cent in the 10 years to January 2015, with an annualised volatility of 34.68 per cent.
The recent crash in the oil price has led a number of natural resources funds to post dire risk-adjusted returns over the period, including the MFM Junior Oils Trust and JPM Natural Resources. Economic sanctions from the West have hit funds with a focus on Russia such as Neptune Russia & Greater Russia and Aberdeen Eastern European Equity even harder.
Performance of funds and index over 10yrs
Source: FE Analytics
Japanese funds, particularly with a small cap bias, have also struggled, as have a handful of financial and property funds which have still not managed to recover from the 2008 crisis.
The only other fund aside from CF Ruffer Baker Steel Gold that has managed to lose money over the period is labelled ‘A’. Brownie points to the first reader to guess the name of the fund in the comments section below…
FE Trustnet will compile a similar study for closed-ended funds in an upcoming article.