Tilney Bestinvest has revealed a series of funds that have managed to beat their benchmark with lower volatility than the relevant index.
Jason Hollands, managing director of business development and communications at Tilney Bestinvest, said analysis of five-year total return revealed many funds that have outperformed their benchmarks without having to chase riskier assets.
In the UK these funds included Evenlode Income, which focuses on businesses that are “cash compounders” with little drag from owning fixed assets (machinery and plant) and Liontrust Special Situations, which targets companies with high barriers to competition (for example, by owning intellectual property, with higher recurring revenues or hard to replicate distribution).
JO Hambro UK Opportunities also featured on Tilney Bestinvest’s list. Its manager is prepared to hold high cash weightings when he believes valuations are too high and the outlook uncertain.
But Tilney Bestinvest’s calculations showed there were some sectors where no funds achieved both benchmark beating returns and less volatility than the index.
In the case of North American funds, all but two funds were more volatile than the S&P 500 index and only four beat the index, which Mr Hollands described as a truly dreadful outcome.
Japan was a market where a modest number of managers did beat the index, but in each case this was achieved with higher volatility than the Topix.
A number of the outperforming funds had much greater exposure to smaller and medium sized companies, which Mr Hollands said might explain the higher volatility they experienced.
In the case of the UK Smaller Companies sector, there were plenty of managers who beat the FTSE Small Cap index but all did so with greater volatility.
Mr Hollands said: “This is almost certain to be reflection of the fact that pretty much all smaller companies funds now partially or substantially invested in Aim stocks, as well as those on the main exchange.”
Adrian Lowcock, investment director of Architas, said the relationship between risk and return was a frequently misunderstood one - that to achieve the same or greater return you must take on more risk.
He said: “This is not the case. You can reduce risk through diversification, which is why it is often described as the only free lunch in investment.
“You have to be careful when comparing sectors. It isn’t really appropriate to compare UK Equity Income managers with smaller company’s managers or the US with UK as each sector has unique characteristics.
“For example, when investing in smaller companies it is naturally harder to reduce volatility as they are likely to be more concentrated than the index so volatility can easily be exaggerated.
“Volatility isn’t a measure of risk of an investment just a way of tracking movements in share prices. It doesn’t reflect the outlook for that investment. In the short and medium term volatility is driven by characteristics of the markets.
“For example the bond proxies, which have supported the equity income sector, have been in vogue over the last few years but as they rise in value the risks have grown, but volatility has come down.
“It is better to use the two measures, than just performance on its own as it helps to weed out those funds, which are closet trackers. i.e. any fund with performance and volatility close to the benchmark is going to struggle to justify a management fee.”
But James Yardley, senior research analyst at Chelsea Financial Services, said while looking at volatility is a good starting point and the results show nicely how risk-aware managers can outperform there are a couple of other aspects he would suggest should also be assessed.
He said: “Volatility doesn't tell the whole story. The first is maximum drawdown. You can also look at this over five years and can see how much you could have lost in a fund from peak to trough.
“This shows you how a fund actually performs in down markets and can be a very good sense check, as well as helping with expectations.
“The second is style bias. Over the past few years lower-risk bond proxy equities have done very well and quality growth funds investing in these stocks have seen lower volatility and performed well.
“The danger is that if you fill a portfolio with too many funds of a similar style, you are actually increasing the risk if the style then starts to underperform. This can also be exacerbated by ETF flows.”
Patrick Connolly, Certified Financial Planner at Chase de Vere, said ultimately we all want to invest in high return low risk funds, and while these are easy to identify with the benefit of hindsight, finding the funds that will achieve this in the future is far more difficult.
He said: “We may be able to find funds which are likely to be lower risk, but in terms of performance many fund managers are inconsistent, they make the wrong calls, their style goes out of favour or they can struggle to manage larger amounts if their fund becomes popular.
“It is usually higher risk funds, where their bets have come off, which sit at the top of the performance tables. However, it is often higher risk funds, where their bets haven’t worked, which are languishing at the bottom.”
