Performance versus risk

Mike Turner – Assistant Research Manager for Funds and DFM

Question: If one fund has generated a return of 20% and another fund has returned 15%, has the fund that generated 20% performed better?

Answer: We don’t know, the performance figures suggest it has but they don’t take into account how much risk the fund manager has taken to achieve the higher performance. It’s possible that the fund manager that generated a 15% return used substantially less risk to achieve the performance, but how do we know if the fund that delivered a 20% return has used risk more efficiently than the fund that delivered 15%?

To give a more detailed answer to this question we need to first identify what we mean by risk, examine the relationship between risk and return and examine the concept of risk-adjusted returns.

For the purpose of this article I’ve extracted five-year annualised performance data for unit trusts and OEICs from Defaqto Engage, along with five-year volatility and five-year Sharpe Ratio figures to illustrate comparisons within sectors of performance in relation to volatility, and to illustrate the differences in volatility from sector to sector.

What is volatility (risk)?

It's the dispersion of fund price over a time period and is commonly measured using standard deviation. The higher the volatility of a fund the greater the variation in price around the fund’s mean.

The below table displays the average five-year volatility across each sector, sorted by highest volatility to lowest volatility:

If we look at the five-year annualised performance in relation to the volatility figures sorted by performance, highest to lowest, in the table below we see that sectors such as China/Greater China, which are inherently volatile, have produced less performance than less volatile sectors such as UK Equity and Bond Income, which has been 58% less volatile than China/Greater China over the past five years and has outperformed the China/Greater China sector by 5.75%.

The Sharpe Ratio measures risk adjusted performance demonstrating the performance in excess of the risk free rate allowing for the volatility of the fund. The Sharpe Ratio is calculated using the average performance of a fund across a time period minus the risk free rate divided by the standard deviation across the same time period.

A variation of Sharpe is Sortino which is calculated using downside deviation instead of standard deviation. The below table is sorted by the sector average five year Sharpe Ratio from high to low. In the table below a Sharpe Ratio greater than one implies that on average funds within the sector have delivered excess return for every unit of risk taken over the last five years.

Nine sectors have on average delivered a return in excess of risk over the past five years: £ Corporate Bond, Property, £ Strategic Bond, UK Smaller Companies, Mixed Investment 0-35% Shares, UK Index Linked Gilts, £ High Yield, UK Gilts and UK Equity and Bond Income.

The five sectors that on average produced the lowest return versus risk were: Global Emerging Markets Bond, Europe Excluding UK, China/Greater China, Global Emerging Markets and Short Term Money Market.

Performance in relation to volatility

In conclusion, it’s important to understand that there's a positive relationship between performance and risk, with the result that that performance also has a corresponding risk level. It's understanding risk-adjusted return that will determine whether risk is being used efficiently as two funds can have returned similar performances but the volatilities of those funds could have been very different.

This is because a fund manager will need to take on additional risk to attempt to achieve extra performance, however, as a result of taking on additional risk there's an increased possibility of loss. A high ratio of performance versus risk can be an indication of efficiency of risk management and/or greater manager skill.

Advisers can use Defaqto Engage to access a suite of analysis tools to examine performance in relation to volatility. Some of the tools available include historic performance, both annualised and cumulative, historic volatility, and ratios including Sharpe and Sortino.