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Does risk really mean better returns?

26 November 2015

Using data from FE Analytics, FE Trustnet looks whether a fund’s downside risk can be a good indicator of its performance over the long term.

By Lauren Mason,

Reporter, FE Trustnet

It’s seen as a truism that investors need to be able to stomach more risk if they are to make their cash work as hard as possible and – hopefully – achieve strong long-term returns.

Good examples of this are the FTSE Small Cap and FTSE 250 indices, which have comfortably outperformed the UK blue-chip index over the last decade but given their investors a rougher ride in the process.

Performance of indices over 10yrs

Source: FE Analytics

Smaller companies are higher risk than large-caps due to issues surrounding illiquidity, a reliance on the fortunes of the domestic economy and greater potential for businesses to ultimately fail. This translates into big swings in prices, especially when investors pull away from this part of the market in times of ‘risk-off’ sentiment.

We can see this through the significantly higher maximum drawdowns, which measures the most an investor could have lost if they’d bought and sold at the worst times, and annualised volatility in the small and mid-cap indices over the last decade compared with the FTSE 100.

Both indices also have a much higher downside risk, a metric that isn’t quoted as much as the ratios mentioned above.

Downside risk is a measurement that focuses solely on negative returns and estimates an asset’s potential to decline in price during negative market conditions, essentially exposing a “worst case scenario” in terms of how much an investor could stand to lose.

“Whereas volatility, or standard deviation, looks at the sum of the squared differences from the mean return and roots them, downside risk only calculates the difference between the mean and lower returns,” FE Research’s Tom McMahon told FE Trustnet yesterday

Of course, this is a backward-looking metric and the past is no guide to the future. But do investors really have to be willing to get badly hurt during down markets in order to achieve strong long-term returns?

Using FE Analytics, we looked at all of the UK equity funds in the Investment Association universe and created two 20-fund composite portfolio of those with the highest and lowest downside risk over 10 years and compared them.


The portfolio of funds with the highest downside risk outperformed the lowest downside risk composite by 14.51 percentage points, providing a return of 123.44 per cent.

Performance of composites over 10yrs

Source: FE Analytics

Out of the 16 UK equity funds that have returned more than 200 per cent over the last decade, the mean downside risk is 5.25 per cent, whereas the mean downside risk ratio for the 24 funds that have returned less than 50 per cent is 5.12.

While this is a fairly close call, it must be noted that two of these funds, Dimensional UK Value and Henderson UK Strategic Income, have returned less than 50 per cent and have high downside risk ratios of more than 6 per cent.

However, our data suggests that there isn’t a direct correlation between lowest risk and low returns, which a number of those with low downside risk outperforming from a total return point of view.

Out of the 28 funds that are in the top-decile for their low downside risk, not one of them is in the bottom decile for its annualised return and only two are in the bottom quartile – Jupiter Income Trust and HSBC Income. It must also be noted though that none of them made it into the top decile either.

Five of these funds have nevertheless managed to achieve a top-quartile performance over this time frame: Trojan Income, Invesco Perpetual Income, Invesco Perpetual High IncomeInvesco Perpetual UK Strategic Income and Aviva UK Equity Manager of Manager.

Similarly, only two of the funds in the bottom decile for their downside risk have managed to achieve top-decile annualised returns; these are Standard Life Investments UK Equity High Alpha and Standard Life Investments UK Equity Unconstrained.

Does this mean that investors are unnecessarily taking greater risks to achieve better returns when there are still top-performing low-risk funds to choose from and high-risk funds generating low returns that should be avoided?


 Dan Boardman-Weston (pictured), investment analyst at BRI Asset Management, isn’t surprised that the results are reasonably close over the last 10 years as he says that turbulent times will have driven managers to invest in stocks that have a more predictable earnings stream and more defensive business models.

“What has helped the lower drawdown stocks is that they often have higher dividend yields, which has become even more attractive in a low interest rate and a high QE environment,” he explained.

“The lesson to take from these results over the time period is that time in the market is more important than timing the market. Although, if you are able to be nimble and more active, it can pay off. If you were to take stance when you perceived markets to be expensive and switched into lower downside funds and, when markets were cheap invested in higher downside funds, then the returns would look far greater.”

Ben Willis, investment manager at Whitechurch Securities, isn’t overly surprised by the results either and says that the volatility seen in markets over the last decade has benefitted funds with higher downside risk, as they tend to be able to generate additional alpha on the upside.

“Volatility over recent years has worked in favour of those ‘higher risk’ funds when markets are rising and in favour of ‘lower risk’ funds during periods of market weakness,” he said.

“The data is tending to show that when investing over a long time period, it doesn’t matter whether you invest in higher risk or lower risk funds, as the differential in return is negligible. However, it is historical data and so cannot be relied upon for future returns. As such, when constructing a portfolio for cautious investors, then the lower risk option is most suitable.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.