Risk and reward are often seen as two sides of the same coin. Reward is easy to measure. It is the investment gains achieved – what your fund or portfolio is worth minus how much you invested. Of course judging the value of that gain is a different issue and until you crystallise gains you merely have paper profits.
But what about risk? Risk when investing in funds such as unit trusts or OEICs, investment trusts or exchange traded funds is normally viewed as volatility of value, peak to trough fluctuations, not the potential for investors to lose all their money. Volatility of fund or portfolio value is caused by multiple factors including market sentiment, currency movements, the asset allocation of a fund or portfolio and the stocks held. In general government and corporate bonds are less volatile than equities, emerging markets assets are more volatile than developed markets and mixed asset funds fluctuate less than pure equity funds.
Conventional wisdom suggests that in order to achieve higher returns investors need to take greater risk. However there is evidence to suggest the opposite may be true. In a recent blog by Terry Smith, manager of the Fundsmith Equity, a brilliant global fund he cites research by Robert Haugen and Nardin Baker from 2012. They analysed stock returns in 21 developed markets from 1990 to 2011 and found that counter-intuitively low risk stocks outperformed high risk ones. They concluded:
“The fact that low-risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent — existing now and as far back in time as we can see. It extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.”
The explicit implication here is that investors can achieve higher returns without taking extra risk. One way this can be achieved is by blending assets that you would instinctively think increases risk. Smith gives an example of adding smaller companies to a global equity portfolio. A change from 100% invested in the MSCI* World Index to 35% in the MSCI World Small Cap and 65% MSCI World Index increases returns but with no additional risk as measured by volatility. For the technicians among you this is an example of an “efficient frontier.”
A similar conclusion is supported by Financial Express (FE) Risk Scores. These are volatility measures of funds over a three year period. The scores and methodology can be found on the FE Trustnet website. Uniquely FE Risk Scores are relative not absolute** measures of risk. This is because the FTSE 100 index is used as a benchmark and this has been assigned a constant volatility measure of 100. For example the Fundsmith Equity has a current FE Risk Score of 108 whilst that for the M&G Corporate Bond is 32. What this means is the Fundsmith Equity is 8% more volatile than the FTSE 100 and the M&G Corporate Bond is 68% less volatile than the FTSE 100 over the last three years. However what I find especially interesting is that if you consider the Investment Association UK Smaller Companies sector 46 funds are listed that have FE Risk Scores. All have scores of less than 100, with many in the 70s and 80s. This seems to blow a hole in the theory that smaller companies are more risky than larger ones. Moreover many of the UK smaller company funds have delivered returns in excess of 50% in the last three years. For example the Marlborough Special Situations rose 59.3% (FE Trustnet 1/9/18). Its FE Risk Score is 83. In contrast the HSBC FTSE 100 Index Tracker (Accumulation share class) which mimics the performance of the FTSE 100 index and re-invests dividends gained just 38.7%. Its FE Risk Score is 100.
A word of caution is needed here. Firstly the FTSE 100 has a high weighting to oil majors, miners and banks which generally have been eschewed by investors in recent years, dampening returns. Moreover commodity stocks are especially volatile being highly geared to the strength of the global economy. This means the FTSE 100 has been hit by a double whammy of low returns and high volatility. If market sentiment changes towards commodities and financials the FTSE 100 could rally and its risk reward profile will improve. On this point banks are looking more attractive with rising interest rates and stronger earnings and balance sheets, allowing a return to payment of dividends. Conversely the fair wind for smaller companies could deteriorate if there is a UK recession. Secondly although there is clear evidence that risk and reward are not correlated it would be wrong to assume this is true in all circumstances. It all depends on what you are looking at. The Haugin and Baker study focused on low and high volatility stocks but that is not the only comparison we can make. As noted equities typically outperform bonds but are more volatile. Similarly an investor moving from a cautious risk portfolio to pure equities should expect better long term returns but more volatile prices.
Finally to assume risk is only about volatility of value is simplistic. There are plenty of other snakes in the jungle ready to take a bite out of your money. Government and corporate bonds carry interest rate or duration risk. Then there is currency risk and fund manager risk. The latter is the potential for fund managers to make big mistakes in their asset allocation and stock selection and for star fund managers to go from hero to zero. Then there is inflation risk which is especially relevant to multi-asset, targeted absolute return and other cautious risk funds. The point is these are all low volatility investments but are subject to a risk that pure equity funds do not carry.
In respect of inflation risk I have recently been assessing the performance of cautious risk funds I have recommended in recent years. I have taken the view that to justify inclusion in a portfolio a fund should have beaten inflation over the last three years. If it hasn’t then the investment has lost value in real terms i.e. it has lost purchasing power. The benchmark I have used is RPI inflation. From July 2015 to July 2018, the latest published data, I calculated RPI was 8.9%. Whilst many defensive funds have significantly outperformed inflation others have failed to do so and have faced the axe.
To finish we need to consider cash. In absolute terms cash has no volatility. If £100,000 is held in a savings account and interest is paid out, the value of the cash will always be £100,000. If interest is accumulated the cash value rises steadily. However its purchasing power or real value decreases if inflation exceeds interest rates. If for example inflation is 1.5% p.a. higher after ten years the real value of the cash drops to £85,973. The point here is there is no such thing as a risk free investment. Risk in one form or another is a necessary evil all investors must take. Hiding your money under the bed is not a solution.
*MSCI – Morgan Stanley Capital International. They produce stock market indices used for benchmarking portfolios and exchange traded funds (ETFs).
**Absolute volatility is measured as the standard deviation of returns around a mean.
The content of this blog is intended for general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.