Conventional wisdom dictates that the higher the risk, the higher the reward but over the last 10 years this has not always necessarily been the case when it comes to investing in funds, according to the latest data from FE Analytics.
In the first of a two-part study, FE Trustnet uses scatter charts from FE Analytics to map the risk-adjusted returns of all sectors in the Investment Association (IA) universe.
The higher the volatility, the higher the potential for future returns over the long term but this also comes with a higher probability of making a loss.
While no IA sector has made a loss over 10 years, it is interesting to note that those that have experienced higher and lower volatility have not necessarily been the worst or best performers.
The chart below shows the return and volatility of every single IA sector over the past decade, and although there is relatively direct relationship between risk and return, there are some anomalies.
The x-axis measures volatility while the y-axis measures total return, enabling investors to compare funds on a risk-adjusted return basis – a phenomenon that has grown ever more important in recent years with the paltry yields on cash and short-dated bonds on offer forcing savers and low-risk investors into ever riskier assets.
Risk-adjusted performance of IA sectors over 10yrs
Source: FE Analytics
Those in the top right of the chart are sectors that have performed strongly but have experienced higher volatility, such as smaller companies and the technology specific sectors.
Meanwhile the bottom left corner consists of lower-risk sectors that have made smaller returns such as cash, mixed asset and fixed interest sectors, with developed market equities sitting somewhere in between.
However not everything follows the trend and some sectors have little to show for their high levels of volatility, while others have given investors the best of both worlds. Below, FE Trustnet looks at some of the more interesting anomalies thrown up by the above chart.
The first area of note is the global emerging markets and Chinese fund sectors, which despite more volatility than any other asset class have made middling returns over the last decade.
Jason Hollands, managing director at Tilney Investment Management, said despite a strong rally in recent years, emerging markets have spent a few years out in the cold during the past decade with particularly tough periods in 2011, 2013 and 2015.
Performance of sector over 10 calendar years
Source: FE Analytics
“These regions have historically been sensitive to international capital flows and in the aftermath of the credit crisis there was a big shift out of volatile regions by investors back into developed markets where equity returns were boosted by the huge stimulus programmes put in place by the US Federal Reserve, Bank of England, and more recently the European Central Bank,” he noted.
“Alongside this, many investors have grown concerned about China’s massive expansion of credit and the potential impact on the wider Asian and emerging market regions.”
Additionally, over the period certain countries suffered as the so-called commodity super-cycle ended, notably Russia and Brazil.
Finally, 10 years ago the sector, which is now on a discount to their developed market counterparts, was actually trading on a premium as investors sought the superior growth rates on offer.
However, he said sentiment is now shifting as China seeks to address these financial risks and countries such as India implement sweeping political reforms. Therefore, the sector could begin to nudge further towards the top right-hand corner in the coming years.
The other underperforming area compared to its volatility is the property sector, which was the worst performing sector outside of cash despite the added risk associated with the sector.
“It is music to my ears because one of my better calls was to take everybody here at Skerritts out of property in 2007 and we’re not back in yet,” said Andrew Merricks, the advisory firm’s head of investments.
He said volatility in the sector is not as straightforward as other sectors, with the lower volatility traditional commercial property funds balanced by the higher volatility funds investing in securities.
But the sector as a whole has underperformed over the past decade because it is still feeling the effects of the financial crisis in 2008, Merricks said.
“The crash in 2008 was born out of the biggest credit bubble of all time and what did most people borrow money for? To buy property,” he noted.
“When you take away the means of credit, which is what happened as people couldn’t borrow anymore, the value of property, whether it was residential or commercial, plummeted.”
Meanwhile the income on offer has shrunk in the low yielding environment with investors buying into any assets that offer a reasonable yield.
“The income that you get from property has been pretty meagre from what I can see. Most of the property funds and for the lack of liquidity you can get 4 per cent from a good equity income fund that you can dump by midday if you want to,” Merricks said.
“It is a completely isolated asset class that will absolutely have its day again and when it does I want to be buying it. But, particularly against the backdrop of rising interest rates, I can’t see that being in the next few years.”
While some anomalies such as the two examples above are more obvious, the chart also shows some more nuanced surprises, such as that investors in the US equities would have made better returns if they had invested in smaller companies.
Since the financial crisis there has been a premium placed on growth stocks but much of the attention has turned to tech giants such as Amazon, Alphabet and Facebook.
As such the market has been pointed to by passive enthusiasts, with the S&P 500 outperforming the IA North America sector by 48.04 percentage points.
When compared to the IA North American Smaller Companies sector average however, the S&P500 index is just 8.76 percentage points ahead.
Performance of sectors and index over 10yrs
Source: FE Analytics
“Small cap is full of opportunities and rife for stockpickers: if you are a good stockpicker you can do well in smaller companies,” Merricks said.
“If you buy a tracker you are making an active decision to buy everything and in a market where 30 per cent of the companies are not making any money that doesn’t seem like a great idea. You are concentrating your risk on those that are doing well, i.e. the FANGS, at the expense of those that are in older-type sectors and companies that are struggling and pedestrian in a low inflation, low interest rate world.
“Generally, in any portfolios that we run we are overweight small caps versus large because if you get a good fund manager in the small cap universe it is like picking up fivers off the street: there are a lot of new sectors coming through that start at the small end and get bigger and you can track them through whereas [with] the large caps it can be companies getting smaller which is not ideal.”
The other interesting anomaly is that both the IA Global Equity Income and the IA UK Equity Income sectors have outperformed the broader IA Global and IA UK All Companies sectors.
“It is the nature of what equity income does and the type of companies that it invests in,” Architas investment director Adrian Lowcock said.
“Companies that produce a dividend by their nature tend to be a bit more defensive – so they are utilities, pharmaceuticals, tobaccos etc. Therefore, they are not as cyclical in their focus and just drive a stronger focus on cashflow and returns to shareholders.
“They are not as volatile in their business models and profits don’t tend to be as volatile so when markets go up and down those stocks trade within a much tighter margin.”
This compares to the wider market, which includes growth stocks that tend to be more sensitive to the economic cycle, sentiment and changes in outlook.
As well as this, the broader sectors also contain a number of passive funds which the equity income sectors do not.
“Passives own everything and would therefore own the expensive parts of the market whereas equity income managers will tend to sell out of because capital preservation is key,” Lowcock added.
“Likewise they wouldn’t own high yielders where the dividend isn’t certain because losing capital can have a big impact on the total return and the income generated.”