Do low volatility funds really work?

Absolute return funds

There are several categories of wealth preserving funds and they do the job in a different way to each other: some use a mix of assets as protection, while others remain focused on equities and use buying and selling strategies to hedge against losses.

Absolute return funds aim to produce positive results regardless of market movements according to a target the fund sets itself. They are designed to protect your capital in a downturn, but may lag in rising markets. Darius McDemott, managing director at Chelsea Financial Services, highlights the BNY Mellon Absolute Return Equity (IE00B3SFH735) and Henderson UK Absolute Return* (GB00B5KKCX12) funds as good options.

BNY Mellon Absolute Return Equity takes a market-neutral strategy and engages in pair trades - placing bets both ways on stocks in the same market in order to profit whatever happens to the broader sector. It held up well in the recent downturn, returning 2.39 per cent between the market peak on 27 April 2015 and 28 January 2016 while the FTSE 100 lost 14.46 per cent. The strategy involves buying similar companies, for example BP (BP.), which it expects to appreciate, while selling others which it expects to fall, for instance Shell (RDSA). In this scenario whichever way the oil price moves the fund makes money if its managers' stock conviction is correct.

Henderson UK Absolute Return and Jupiter Absolute Return (GB00B6Q84T67), recommended by both by Rob Pemberton, investment director at HFM Columbus and Adrian Lowcock, head of investing at AXA Wealth, take a different tack and use a long/short equity strategy. The funds balance a book of long positions (buys) with short positions (sells) to smooth returns, though not necessarily in the same markets.

Since the start of the year Jupiter Absolute return has grown 5.08 per cent compared with a FTSE 100 loss of 5.25 per cent.

Henderson has been particularly impressive over three years having returned almost 30 per cent compared to the FTSE 100 which made just under 5 per cent.

Newton Real Return* (GB00B8GG4B61), also highlighted by Mr Lowcock is a different type of strategy. It is a multi-asset fund and categorised within the Investment Association (IA) Targeted Absolute Return sector, but is heavily weighted towards equities and takes macro views on markets, basing its stock selecion on this. Instead of shorting stocks it uses derivatives to generate additional income.

Mr Lowcock says: "Manager Iain Stewart's first priority is capital protection and then he looks to deliver returns of 4 per cent above cash per annum over the longer term. Stewart runs an unconstrained and flexible approach which initially uses Newton's thematic research to identify opportunities and to position the portfolio appropriately."

This fund has more in equities than many similar options in the Targeted Absolute Return sector and as such carries higher risk. But it is more likely to participate in any upside associated with an equity rally. Between 27 April 2015 and 28 January 2016 it fell 3.39 per cent, but during the 2008 crash returned 4 per cent against a FTSE fall of almost 30 per cent.

Two funds not housed in the Targeted Absolute Return sector but also focused on protecting capital are CF Ruffer Total Return (GB00B80L7V87) and closed-ended Personal Assets Trust (PNL), both of which have solid reputations for preserving capital and minimising volatility.

Mr Pemberton says Ruffer and Newton have "well diversified portfolios of equities and fixed income with a bias to index-linked bonds, and may on occasions hold gold and large positions in cash or very short-dated bonds."

CF Ruffer Total Return has 13.5 per cent of its assets in cash and over 45 per cent in stocks, where it also has some short positions. The fund's aim is to achieve low volatility and positive returns, but it sets no target for those returns. It has not always met its aim in recent years, with its total return falling in 2015 and in the year to date. It also holds up the least well when compared with the other funds in the table between the market peak and 27 January, having lost 8.6 per cent. But that was still less than the FTSE 100 and FTSE All-Share which both dropped by almost 15 per cent over that period.

In contrast Personal Assets Trust has performed well, losing just -0.1 per cent between April 2015 and January. It has also returned positive results every year since 2009 apart from in 2013 when it lost 4.75 per cent during a bull market for equities in which the FTSE 100 and FTSE All-Share both gained around 20 per cent. Its strategy is expected to do well when markets crash - as evidenced in its minor 3.2 per cent fall in 2008 when the FTSE All Share shed almost 30 per cent.

The trust is run by renowned manager Sebastian Lyon, who also runs Troy Trojan Fund (GB00B01BP952), using a similar strategy.

Performance (% total return)

*Main share classes - could be different to recommended share classes

**27 April 2015-28 Jan 2016

Source: FE Analytics, as at 29.01.2016

Data crunch: the least volatile fund

Analysing returns is one way of assessing how these funds compare to each other in terms of preserving capital but a look at risk metrics gives a fuller picture of how volatile each one is. For each fund we looked at:

■ downside risk which assesses the likelihood of capital loss - the bigger the figure, the higher the risk; ■ maximum drawdown, which shows the maximum amount a fund would have lost if you bought at its peak and sold at the worst time; and

■ maximum loss - the worst possible loss in an investment period.

In each case, a larger number indicates a worse scenario. The figures are expressed as a monthly average.

The picture for capital preservation funds is positive in general. All have lower risk metrics than the FTSE 100 and FTSE All-Share, with far lower downside risk than these indices as well as MSCI Europe. The best on that measure is BNY Mellon Absolute Return Equity, with a score of under -1 per cent, demonstrating that even if you bought the fund at the top of the market and sold at the crash in January, you would only have lost 0.7 per cent of your investment - an impressive feat considering the FTSE peak to trough journey shaved 12.1 per cent off the value of the index.

BNY Mellon also comes top in terms of downside risk. While the indices analysed all posted downside risks of over 14 per cent for the period, BNY Mellon has a downside risk of under 2 per cent.

Monthly maximum losses also come in way below the indices proving that average losses are less, and returns are less volatile even in periods of market stress.

Risk and volatility comparison

Source: FE Analytics, as at 29.01.16

Low volatility passive funds: win win?

But when it comes to protecting returns passive funds are winning on every front, delivering higher returns at lower risk for half the price. Multi-asset funds have a reputation for being more costly which is not the case with the relatively new range of low volatility exchange traded funds (ETFs). And the low volatility ETFs have displayed staggering outperformance compared with their original, volatile ETF counterparts on risk metrics as well as share price performance.

Paul Taylor, managing director at McCarthy Taylor, says: "Absolute return funds are not only costly, historically they have also tended to struggle to deliver on their promises. We prefer the iShares MSCI World Minimum Volatility UCITS ETF (MVOL), managed by BlackRock, currently the world's largest investor."

Low volatility is one of the best areas of ETF innovation in recent years. It is one of the most common and successful smart beta strategies - whereby ETFs track an index in which stocks are weighted according to a metric other than market cap. The products are very low cost and have delivered on their promises, often returning more to investors while also giving a smoother ride.

The results are impressive. iShares MSCI Minimum Volatility UCITS, Amundi ETF MSCI Europe Minimum Volatility (MIVO) and Ossiam FTSE 100 Minimum Variance (UKMV), which we have chosen as a random sample, have each returned vastly more than their traditional counterparts over three years. iShares MSCI World Minimum Volatility has delivered vastly more than iShares MSCI World UCITS ETF (IDWR) at over 41 per cent compared with just 27 per cent, and Amundi has more than doubled the returns of its plain vanilla European equivalent, returning over 30 per cent compared with 11 per cent for Amundi MSCI Europe ETF.

Performance (% cumulative total returns)

Source: FE Analytics, as at 29.01.16

Normally to earn higher returns you have to take more risk, but these funds have managed to deliver better total returns at a lower risk, according to the data. Each ETF analysed had a lower downside risk over the period from market peak to January. The best was iShares MSCI World Minimum Volatility, which posted a downside risk of 10.9 per cent compared with 16.36 per cent for iShares Core MSCI World UCITS ETF. Ossiam FTSE 100 Minimum Variance UCITS ETF had no comparable product so was compared with the FTSE 100 index.

These ETFs also won when it came to monthly maximum drawdown. Amundi ETF MSCI Europe Minimum Volatilitywas particularly strong, with a loss from peak to trough of just 5.9 per cent compared with a drop of 10.8 per cent for Amundi ETF MSCI Europe. Monthly maximum loss figures were also better for every ETF than their non-volatility weighted indices and comparable ETFs.

Risk and volatility comparison

Source: FE Analytics, as at 29.01.16

*IC Top 100 Fund

Low volatility and original ETF top holdings

Source: Morningstar, as at 31.12.15

Low volatility and original ETF sector allocations

Source: Morningstar, as at 31.12.15