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Printed: 05 July 2022 11:31 PM

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01 Jul 2021 - Does Higher Volatility Translate into a Higher Return?
By: Australian Fund Monitors

Does Higher Volatility Translate into a Higher Return?

Australian Fund Monitors

30 June 2021


There is a long held ideal that when investing in equities, the level of volatility is correlated to the return; the more risk you put on the table the greater the return you expect to get back. Of course, the amount of time invested also needs to be considered, but for investments over 3 years (and beyond) this ideal is generally accepted, as evidenced by the number of scatter graphs used in fund marketing material.

Volatility is managed by fund managers in several different ways, but generally it comes down to portfolio construction. The number of stocks in the portfolio, the size of the position held in each stock (and sector), and the buy and sell triggers, all affect the volatility of the portfolio.

Typically, the funds management industry uses Standard Deviation as a measure of volatility. Standard Deviation measures the dispersion of monthly returns both above, and below the average monthly return. The smaller the funds standard deviation, the less volatile it is. The larger the standard deviation, the more dispersed the returns are and the more volatile it is.

But does this show through in data, and is past volatility any sort of indicator of how a manager should have performed?

We have looked at the returns and standard deviation over the past 3 and 5 years of all Long Only Australian Equity Funds (107 funds) on the www.fundmonitors.com database and broken these into quintile rankings. The funds with the best performance fall into the 5th quintile (best) and funds with the lowest standard deviation fall into the 5th quintile (best).

Looking at the data over 3 years as at the end of May 2021:

  • Of the 22 funds that made up the 5th quintile for performance, only 9 of them were in the 1st quintile for standard deviation, showing that strong performance does not require higher standard deviation.
  • One of the funds in the 5th quintile for performance was also in the 5th quintile for standard deviation and 4 of the funds were in the 4th quartile for standard deviation.
  • At the other end of the spectrum, only 6 the funds in the 1st quintile (22 funds) for performance (worst performers) were in the 5th quintile for standard deviation showing that standard deviation and return are not correlated over this timeframe.

Running the data over 5 years shows that standard deviation and return become slightly more correlated:

  • 12 of the 19 funds in the 5th quintile for performance were also in the 1st or 2nd quintile for standard deviation.
  • For funds in the 5th quintile for performance the average 5-year performance was 16.14% p.a. and the average standard deviation was 19.03% p.a.
  • For the funds in the 1st performance quintile the average 5-year performance was 6.48% p.a. and but the average standard deviation was quite high at 15.27% p.a.

Clearly, while there is some minor correlation in this data, the ideal of using standard deviation as a measure of manager skill, especially in isolation, is not a prudent investment conclusion. Investors and advisors should be looking at multiple risk data points such as Sharpe Ratio, Sortino Ratio, Up and Down Capture and Downside Deviation, to help them make the most effective investment decisions.


If you'd like to do this sort of analysis of fund performance yourself, have a look at our Fund Selector and Custom Statistics tools.

 

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