Behind the numbers: Why high risk doesn’t always equal high returns

It is commonly asserted in the financial adviser community that if you are prepared to take more risk with your money, over the long term you should be rewarded with higher investment returns. It’s the much quoted risk/return ratio, but research we have conducted at FE shows that this doesn’t always stack up.

Prior to the release of a paper by the FCA early next year which will look at risk and advice, we did some research which shows that some 70 per cent of advisers build their clients’ portfolios to given risk targets.

With this in mind we wanted to examine the hypothesis further , in this risk-focused world, what does the relationship between risk and return look like in reality? The answers were somewhat surprising.

For the purpose of this article we have looked at funds in the IA UK All Companies sector over both three and five years, comparing the cumulative returns the funds have generated versus the volatility taken.

First let’s look at what happened over three years, a time period in which the FTSE All Share generated a total return of 15.7 per cent, with a three-year cumulative volatility score of 9.34. Out of a sector of 256 funds, a quite worrying 124 funds that took more risk than the index actually ended up underperforming it. That equates to nearly half (48.4 per cent) of the peer group.

Indeed the number of funds that took more risk than the index and underperformed was more than the 108 funds (42.2 per cent) that took more risk and outperformed. Meanwhile those funds that were able to produce higher returns with lower risk was virtually zero. There were only 20 funds that were less volatile than the index and of these funds just 11 produced a superior return.

What does this mean in practice? Well, it means a huge number of funds are simply not cutting the mustard. Of course, it has to be remembered that the last three years have been a massively volatile time period and the numbers may have been skewed by what happened in 2016.

The fund which achieved the highest return over the time period and took less risk than the index was the MFM Bowland fund run by Marlborough Fund Managers. It returned 51.4 per cent over the time period, with three-year cumulative volatility of 9.28. At the other end of the scale, the Jupiter UK Growth fund only managed a return of 5.09 per cent, but took nearly six percentage points more risk than the index, with a volatility score of 15.16.

Indeed what is telling about these numbers is that no group seems to come out on top or bottom. While the Jupiter UK Growth fund struggled over three years, Ben Whitmore’s Jupiter UK Special Situations was one of the 11 funds which managed to beat the index with lower volatility – returning 26.9 per cent, with 9.24 volatility.

One fund management house which does do well, however, is Threadneedle. While its UK Growth & Income fund was the only one of its UK offerings which took less risk and outperformed the index, its seven other funds in the peer group (UK, UK Growth, UK Select, UK Mid 250, UK Extended Alpha, UK Overseas Earnings and UK Institutional) all managed to outperform the index by taking more risk.

2016 was a very volatile year with the shocks of Brexit and Donald Trump getting into the White House. As a result many funds adopted more volatility in their hunt for gains, leading to large sector and style rotations, and these changes could have fed through to the three-year numbers.

So how do the same set of funds fare over five years? Over this time period the FTSE All Share index returned 55.4 per cent, with a cumulative volatility of 9.96. The good news is that just 56 out of 245 funds (23 per cent) in the IA UK All Companies sector that took more risk ended up underperforming. This is significantly less than 42 per cent of funds which took more risk and underperformed over three years. Additionally the number of funds which took less risk and outperformed jumps from 11 funds over three years, to 26 over five.

Of the funds that took less risk and still outperformed, the SDL UK Buffettology fund achieved the highest return over the time period, up 158 per cent. Taking the lowest amount of risk among these funds was Carl Stick’s Rathbone Income fund, but he still returned 81.2 per cent versus the index gain of 55.4 per cent.

Taking the unfortunate honour of being the fund with the lowest return, but which took more risk in achieving it, is Scottish Widows UK Select Growth. Over five years it returned only 15.4 per cent, but in doing so its volatility was 11.05. The point is that you want the benefits of active management to bear fruit during these sorts of conditions and with a political outlook suggesting that more volatility is on the horizon, now is an opportunity for active management to prove its real value.

With fewer people on final salary schemes and more self-management taking place in pension schemes, it is a discussion that many advisers and investors will have to spend time on.

The conversation is moving on from how much risk you are willing to take, to how much risk do you need to take to get a pension pot which you can comfortably retire on.

Look at it from a betting man’s perspective. Over three years, if you aren’t prepared to take any risk, just 11 funds out of 256 were able to produce a superior return than the index. Not great odds. However if you are prepared to stomach the risk, while these numbers show the majority of funds did pay off, there remained a one in five chance of not getting it right.

The challenge for the active management industry is to prove that the additional risk is worth taking.

Over five years the scorecard reads better, but these numbers were generated in what I would term the old world. A world in which monetary policy across the globe was being used to prop up economic growth, with resulting low interest rates and low bond yields.

Today a new political and macro world is on the horizon, or in fund management speak with interest rates set to rise, inflation moving up and bond yield expected to increase we are at an “inflection point”. If this is the case, it represents an incredible opportunity for managers to outperform, but as these numbers show, grasping that chance might  not be as clear-cut as it seems.

Mika-John Southworth is a director at FE