On a year-by-year basis, investors have been poorly rewarded for taking on higher risk from funds in the IA UK All Companies sector over the last decade, according to data from FE Analytics.
The old and well-known adage is that the higher the risk the higher the reward, but this has not held up over the past decade for investors in the sector.
For this study we are measuring risk as a fund’s volatility. We have taken the 20 per cent of funds in the sector with the lowest and highest volatility in each calendar year over the past decade and looked at the difference in average returns that was generated by each of the two buckets.
Between 2008 and 2017, funds in the top quintile for volatility (and therefore the lowest-risk) outperformed those in the fifth quintile (the highest risk) in six of the 10 years.
Moreover, in these years they have outperformed by an average of 5.94 percentage points.
Conversely, in the four years that the higher-risk funds have outperformed, they have done so by an average of 4.84 percentage points.
Table of returns from top and bottom quintile volatility funds
Source: FE Analytics
These results would therefore suggest that investors have been better off in a lower-volatility strategy than by taking on more risk to drive higher returns.
Aqib Hashamali, UK investment analyst at City Asset Management, said: “I think the conclusion that is reached is pretty applicable over the last 10 years given the way the world has moved.
“We have seen a higher demand for those companies that have stable earnings and can convert that into cash and therefore pay out dividends.”
Indeed, so-called ‘bond-proxies’, and sectors such as consumer staples in particular, have been among the top performers in the UK market over the last decade.
These stocks, which typically have a reasonable dividend yield and single-digit growth, are likely to be very well represented in the portfolios of the funds in the low volatility bucket.
“I would be very surprised if [the low volatility funds] did not also have a relatively high dividend yield compared to those funds in the bottom quintile for high volatility,” Hashamali said.
But he noted that this is very specific to the last 10 years since the global financial crisis in 2008, where low interest rates and quantitative easing have pushed bond investors into more defensive equity names.
Similarly, from the other end, investors burned by the crisis may have been tempted down the risk curve into ‘safer’, more steady stocks.
“I don’t think this relationship is true over a longer time period on a rolling basis but I think give the creation of low volatility ETFs in the UK and the US the amount of capital that has flown through consistent earning and dividend conversion stocks, it is what is driving this figure here,” Hashamali said.
However, he added that over the longer term, investors have been rewarded for taking higher risk and that he would expect this phenomenon to mean revert.
“I think it is the time period that you are looking over rather than it being a hard and fast reason for not taking on more risk in the UK and I think over the longer term you would expect some of that to revert,” he said.
“As a whole I don’t think this is UK centric but that it [mean reversion] will drive opportunities for excess returns in the future.”
George Lagarias, senior economist at Mazars Wealth Management, said however that the figures above don’t even make for a compelling argument against taking risk.
“Six out of 10 [years] and a percentage point difference [per year] doesn’t seem statistically conclusive and I think it’s largely circumstantial,” he said.
“For one, you have 2008 in the calculation which skews the numbers while in 2014-16 investor interest in yield surged, so high yielders, usually lower volatility stocks such as telecoms or utilities were high on the preference list.”
He added: “Given that international investors are now interested in materials and energy, both volatile sectors which feature multinational companies just listed in London, a bet against volatility could end up being a bet against sectors that attract international interest, especially at the age of Brexit.”
When looking at it over the last 10 years as a whole rather than breaking it down per calendar year, however, it is interesting to note that more funds that are top quintile for total return have been bottom quintile for volatility.
Table of top quintile performers with highest quintile volatility
Source: FE Analytics
This could suggest that, over the whole period, investors have indeed been rewarded for taking on higher levels of risk.
Indeed, half of the top quintile of 40 funds are among the most volatile members of the peer group, as the above table shows.
A number of mid-cap funds dominate the list, with the best performer of the group (and fourth-best in the sector) being the £3.6bn Old Mutual UK Mid Cap fund run by FE Alpha Manager Richard Watts.
Analysts at FE Invest said the fund is “contrary to many of its peers as the team takes into consideration the economic environment and does not only focus on stock selection.
“Stock selection is the main driver of performance but the team’s ongoing assessment of the economy helps to shorten periods of underperformance.”
Five funds in the bottom quintile for volatility meanwhile also sit in the bottom quintile for performance.
Conversely, only five funds in the top quintile for returns have managed to slot into the lowest quintile for volatility.
Table of top quintile performers with lowest quintile volatility
Source: FE Analytics
Three of the funds on the list – Aviva Investors UK Equity MoM 1, LF Lindsell Train UK Equity and Liontrust Special Situations – are among the top five performers in the sector.
Only four funds with bottom quintile volatility sit in the bottom quintile for returns over the period.
The best performing fund in the sector over the last decade – Slater Growth – has exhibited fourth-quintile volatility.