When it comes to investing over the longer term the balance between risk and reward is reasonably clear: it pays to take on risk.
Our data shows that taken on average over five, 10, 15 and 20 year periods there is a trend to higher returns in sectors that have higher volatility.
In the graph shown below total return is plotted along the ‘Y’ axis while volatility is plotted against the ‘X’ axis, giving some measure of risk-adjusted returns over time of every single IA sector over the past decade, and there’s clearly a direct relationship between risk and return.
Those toward 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 only managed to eke out a small return and of course vice versa.
As you can see the in the bottom left hand corner you have sectors such as the IA Money Market and IA Short Term Market while at the opposite ends of the axis you have the IA China/Greater China and IA European Smaller Companies sectors.
Risk-adjusted performance of Investment Association sectors over 10yrs
Source: FE Analytics
However, for two of the most popular sectors in the Investment Association the relationship between risk and reward reversed its longer term trend in 2015 with a clear benefit to holding less volatile funds noticeable in the data.
In this article we take a closer look within the IA UK All Companies and IA UK Equity Income sector from the point of view of risk and return.
As the graph below shows that in 2015 the trend rate of risk-adjusted returns moves from the top left to bottom right quadrant compared to the other way around over the longer term.
One fund that jumps out is Keith Ashworth-Lord’s ConBrio Sanford Deland UK Buffettology which has the highest return of any fund in the two sectors but also delivered just two just thirds the volatility of the FTSE All Share index.
Performance of fund, sector and index in 2015
Source: FE Analytics
This is despite Ashworth-Lord, who follows the process of legendary investor Warren Buffet, running a concentrated portfolio of 27 stocks which in turn is biased towards mid and smaller companies.
The fund also has had the fourth lowest maximum drawdown – which measures the most an investor would have lost if they had bought and sold at the worst possible time – in the 270-plus strong sector in 2015.
The £16m PFS Chelverton UK Equity Growth fund offered investors one of the smoothest rides last while also clocking up one of the strongest returns. The same can be said for the MFM Bowland as well as the five Crown-rated CF Miton UK Multi Cap Income funds.
Risk-adjusted performance of UK equity funds in 2015
Source: FE Analytics
The £586m CF Miton UK Multi Cap Income fund is co-managed by Gervais Williams and Martin Turner and has a substantial 32.5 per cent weighting in FTSE AIM stocks, as well as a 22.5 per cent weighting in the FTSE 250 and 17.3 per cent in Small Caps.
It is this stock distribution combined with a large number of holdings that Williams says provides extra security against potential headwinds.
Other funds worth mentioning include Unicorn UK Income, MFM Slater Income, Montanaro UK Income and Old Mutual Dynamic Equity as well as FP Miton Undervalued Assets.
These funds as well as the others already mentioned tend to mostly invest in mid and small caps which as Rob Burdett (pictured), co-head of the F&C MM Navigator range, points out have been more immune to the broader UK equity market’s volatility.
“In the rout last year and so far this year, we have seen small and mid-caps outperform in a falling environment whereas in previous environments they have often borne the brunt of it,” Burdett said.
He thinks this trend should continue this year with larger caps stocks continuing to be more volatile.
“There is valuation support for that to continue and they are less geared to the problems which have caused these falls.”
Not all of the funds with best risk/returns profiles last year were pure small and mid cap funds with several more weighted to larger caps also worth mentioning. This include Artemis UK Growth, Premier UK Growth and Liontrust Special Situations.
On the flipside those that scored a position on the bottom right hand corner of the graph all tend to be more associated with a value/recovery style of investing.
Sticking out most is David Cumming’s £33m Standard Life Investments UK Equity Recovery fund which made a near 8 per cent loss and had significantly higher volatility than the index.
Value as a style has been somewhat out of favour of late, particularly for funds whose main stomping ground is the FTSE 100 with shocks to oil & gas, miners and other natural resources firms an ongoing event.
Other funds that follow this pattern include Schroder UK Recovery and Dimensional UK Value.
However, many market commentators expect value, as a style, to come back into the favour over the short to medium term.
“Sentiment and the relationship between value and quality looks quite stretched and sentiment is very, very, very negative in areas like resources, for example, and cyclicals generally,” FE Alpha Manager Martin Walker said last year.
