Buffett pointed out that a diversified portfolio of stocks will have handed investors significantly larger gains than cash or other perceived safe asset over a multi-decade investment horizon.
“If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in ‘safe’ treasury bills or bank certificates of deposit,” he said.
“People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement.”
Buffett’s comments were well received by FE Trustnet’s contacts in the investment industry and our readers. F&C’s Rob Burdett, for example, said there has effectively been “a bear market in risk-taking” over years.
“In general terms we have been saying for some time that the effects of a ‘lost decade’ – or more – for the FTSE have scarred and scared investors – and perhaps their advisors and the industry – to such an extent that the risk is investors don’t take enough risk to meet their personal long-term needs and goals and sit there in cash underperforming inflation,” he added.
While FE Trustnet completely agrees with Buffett’s views that riskier asset classes like equities better serve some investors than cash and bonds over time, we couldn’t help but notice that some of the comments about Buffett’s views seemed to argue that the volatility of funds was therefore unimportant.
Long-term readers of ours will know that we frequently reference funds’ annualised volatility when writing about them and this approach has sometimes brought criticism from commenters who believe this metric is not relevant.
Given that Buffett was speaking about the volatility of asset classes and not individual funds, we thought we’d look into whether holding the least volatile funds in a volatile asset classes makes a difference or not.
To do this, we built equally-weighted portfolios of several sectors’ most volatile funds over the past 10 years and portfolios of their least volatile peers, then compared them to see how the average fund in each did. It must be noted that this is based on historical data, which is no guide to how the future will pan out.
First up was the IA UK All Companies sector, as it’s the largest peer group in the Investment Association universe. As the graph below shows, this appears to show that the most volatile members of the sector have been the best bet over the past decade.
Performance of portfolios over 10yrs
Source: FE Analytics
However, the fact that this massive sector is such a mixed bag of funds explains why the most volatile portfolio outperformed.
Many of the members of the least volatile portfolio are familiar names such as Mark Barnett’s Invesco Perpetual Income and High Income funds (which were of course previously managed by Neil Woodford), Ben Whitmore’s Jupiter UK Special Situations fund and the team-managed Majedie UK Focus fund. Funds here tend to have a decent chunk in large caps.
However, a lot of members of the most volatile portfolio focus on opportunities further down the cap spectrum with examples including Old Mutual UK Mid Cap and Franklin UK Mid Cap. The potential for higher gains in this part of the market means that some members have 10-year returns well in excess of 250 per cent.
Looking at the IA UK Equity Income sector allows for a more like-for-like comparison between styles of funds. Here we can see that the average least volatile funds has returned more the most volatile vehicles over 10 years.
Performance of portfolios over 10yrs
Source: FE Analytics
The least volatile portfolio contains several funds that have handed their investors strong returns over the years. FE Alpha Manager Francis Brooke’s Trojan Income has annualised volatility of just 9.76 per cent but its 151.55 per cent return is more than 45 percentage points higher than the sector’s.
Other UK equity income funds with low volatility but high returns include Adrian Frost and Adrian Gosden’s Artemis Income and Leigh Harrison and Richard Colwell’s Threadneedle UK Equity Income funds. Frost, Gosden and Harrison are FE Alpha Managers.
Interestingly, the most volatile portfolio has beaten the least volatile one in six of the last 10 full calendar years. However, the least volatile funds’ outperformance stems from the fact that they lose much less in down years while still achieving decent absolute gains in stronger years.
A look at the IA Global sector shows a similar result to the UK equity income funds, with the least volatile funds returning about five percentage points more over 10 years.
Performance of portfolios over 10yrs
Source: FE Analytics
As you can see, the journey here has been very different with there being times in the past when the most volatile portfolio significantly outperformed while the least volatile funds’ outperformance has been more muted. Adding to the problems with this sector is the fact that it seems a hard place for active managers to outperform.
Some investors may prefer the more volatile approach and hope to sell at the high points, although this strategy is very difficult to execute in reality.
The least volatile global portfolio, which includes the likes of Schroder MM International, Fidelity Global Health Care and GAM Global Diversified, has also beaten the other collection of funds over one, three and five years. It has also been much stronger in down years, losing 17.75 per cent in 2008, for example, when the most volatile funds dropped by 32.69 per cent on average.
It’s when we take a look at the some of the most volatile equity sectors that the merits of funds with lower volatility profiles really stand out.
In the IA Asia Pacific ex Japan sector, the least volatile funds have made an average of 40 percentage points more than their most volatile peers – a return of 228.55 per cent compared with one of 187.53 per cent.
Performance of portfolios over 10yrs
Source: FE Analytics
The same is also true of the IA Global Emerging Markets sector, where the gap in 10-returns grows to around 50 percentage points.
Performance of portfolios over 10yrs
Source: FE Analytics
The lower volatility Asian funds include well-known names such as Schroder Asian Income and First State Asia Pacific Leaders, while the equivalent global emerging markets portfolio featured Aberdeen Emerging Markets Equity and JPM Emerging Markets.
The difference in average returns in these two sectors make a compelling case for seeking funds that offer a smoother ride even when an investor is happy going into an asset class which tends to display much levels of volatility.
Of course, we’re not saying Warren Buffett is in any way wrong – far from it. However, it would be wrong to believe that his views on asset classes can automatically be applied to choosing individual funds.
Investors have to keep in mind that fund selection and asset allocation are two very different matters and while chasing volatility may work in one of them, this does not mean it will for the other.
