You Can Judge a Fund by Its Volatility

Actively managed funds with high levels of volatility are likely to stay highly volatile and those with low volatility are likely to continue to experience low volatility.

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Unlike returns, fund volatility can be persistent, according to an S&P Dow Jones Indices study. Actively managed funds with high levels of volatility (as measured by the variance in returns) are likely to stay highly volatile. Actively managed funds with low volatility are likely to continue to experience low volatility.

S&P Dow Jones Indices split actively managed U.S. funds into five quintiles. Excluded from the analysis were index (passive) and leveraged funds. Monthly return data from June 2007 through June 2015 was used. During this period, an average of 80% of U.S. funds were more volatile than their category benchmarks.

Nearly half (47%) of the least-volatile U.S. funds in a 24-month period remained in the least-volatile quintile over the subsequent 24-month period. An additional 23% ranked in the second-least-volatile quintile. At the other end of the spectrum, almost two-thirds of the most-volatile funds remained in the two most-volatile quintiles (43% and 23%, respectively) over the subsequent 24-month period.

Higher-volatility funds allocate more to higher-beta stocks, as would be expected. Investors are not being adequately compensated for the larger variance in fund returns, however. A hypothetical portfolio made of funds whose full-period (June 2007 through June 2015) volatility ranked in the top 20% of all U.S all-cap broad and U.S. large-cap broad funds underperformed the S&P 500. The annualized return for the higher-volatility fund portfolio (HVFP) was 7.8%, versus 7.9% for the S&P 500. This underperformance occurred even though annualized volatility was nearly three percentage points higher for the HFVP portfolio: 17.2% versus 14.7%.

The lower-volatility fund portfolio (LVFP) underperformed with an annualized return of 7.2%. (The LVFP also underperformed the S&P Low Beta United States Index.) This portfolio was less volatile than the S&P 500 index, however, with annualized volatility of 13.2%. The study’s authors attribute the return characteristics of low-volatility funds to a “significant cash allocation.” To prove their point, they constructed a hypothetical fund portfolio with an 89% allocation to the S&P 500 and an 11% allocation to cash. The performance of the LVFP was almost indistinguishable from this S&P 500/cash mix.

Source: “The Volatility of Active Management,” Tim Edwards, Craig Lazzara and Luca Ramotti, S&P Dow Jones Indices.