How to analyse a fund's risk/reward profile

Often called the average return, the 'mean return' is the easiest method for understanding a fund's past performance. You simply add up all a fund's returns over a period of time - typically three years - and divide the sum by the number of years. The advantage of this statistic is that it's simple to understand, but it can be heavily influenced by extreme outliers.

Darius McDermott, managing director at FundCalibre, says: "The mean return can be affected where returns are split into two likely outcomes, for example, if a portfolio goes up or down a lot the mean will be somewhere in between - a result that doesn't typically happen."

A lot can be hidden in an average number, adds Mick Gilligan, head of research at wealth manager Killik. "Let's say you are looking at two funds over a three-year period," he explains. "One of those funds could have chugged away gently upwards, while the other could have risen sharply, fallen sharply and risen again, but they both end up in the same place with the same number."

So rather than the mean return, both Mr McDermott and Mr Gilligan prefer to use standard deviation and Sharpe ratio figures when analysing a fund.

'Standard deviation' is one of the most common measures of risk used by investment professionals when measuring a fund's volatility. Standard deviation tells you how spread out a fund's returns are and how variable returns are compared to the mean return.

When a fund has a high standard deviation, the predicted range of performance is wide, implying it will have greater volatility. This is useful for understanding how variable a fund's returns have been, but it does not tell you anything about the nature of the variability - whether it has been positive or negative. And it does not give you a good indication of future volatility.

"Standard deviation is a backward-looking figure, but can guide your expectations of what you would expect to see in [terms of fund performance] in the future under normal market conditions," says Carlos Lucar, analyst and research manager at Morningstar. "Sometimes investors tend to think that volatility is bad and therefore high standard deviation is bad. But standard deviation includes both upside and downside deviation, so penalises good volatility and upside deviation."

There are other statistics you can look at that will strip out the upside and just measure the downside deviation, including semivariance, adds Mr Gilligan. This is a measure of the dispersion of all observations that fall below the mean or target value of a data set. 'Semivariance' calculates an average of the squared deviations of values that are less than the mean.

Mr McDermott argues that standard deviation is a better statistic than mean return because it is not as affected by extreme variables and is useful for comparing funds to each other. But he says it can also mask volatility and produce varying figures depending on whether you base the calculation on daily, weekly or monthly returns.

"While standard deviation is an important measure of risk, it can be deceptive," he says. "For example, volatility can be understated for smaller companies funds because the underlying stocks may not trade as much as their larger counterparts, but this does not mean they are less risky. Also, a low volatility environment, as we have now, may be underestimating future volatility and risk."

Also known as the 'reward-to-variability' ratio, the Sharpe ratio (developed by Nobel laureate William F Sharpe) measures how much return a fund generates for each amount of risk it takes. It does this by looking at a fund's returns minus the so-called risk-free rate - the yield available on government debt - and dividing this against its standard deviation. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

"The Sharpe ratio adjusts a fund's returns over the risk-free rate, which nowadays is close to zero, over the level of volatility of return," says Mr Lucar. "If you're looking at a very volatile fund you want to use this statistic to see whether the manager is actually using the volatility to generate attractive returns - a positive figure of above one will tell you it is generating a point of return for each point of volatility."

This ratio is relatively easy to calculate and makes it easy to compare funds with each other, as the higher the result the better, explains Mr McDermott. However, one drawback of the statistic is that it only measures the overall portfolio return and this can mask extreme variables. This is because if the Sharpe ratio has been calculated against a data sample that is unrepresentative of likely future pay-offs, it can be misleading.

Nevertheless, Mr McDermott thinks analysing a fund's Sharpe ratio is a good starting point for investors when considering a fund, although investors should also look at other factors, including maximum drawdown.

Maximum drawdown shows how much the value of a fund has fallen from its peak to its trough, and is effectively a measure of the maximum amount a fund would have lost if you bought at its peak and sold at the worst time. By measuring the amount you would have lost at a given point in time, maximum drawdown helps investors understand if they are comfortable with past losses compared with the returns delivered. But as a statistic that measures a particular historic point in time, it does not give a clear indication of how a fund is likely to perform in the future.

"It is important to look beyond volatility," Mr McDermott says. "We also examine how a fund has fallen during past market falls and try to understand why it has out- or underperformed. For example, was the manager making a particular call or is he/she always long cyclicals/defensives? That lets us understand how the fund should perform in the future."

Putting it all together

Risk statistics can provide a useful insight into a fund's past behaviour, but they should not be the only factors you use to choose a fund. As well as not providing information on possible future performance, these statistics don't address many important factors.

"These statistics ignore, or at least won't fully pick up on, many other risks such as currency, country, sector, concentration (where a fund is heavily invested in a small number of stocks) and style risk," says Mr McDermott.

Investors also need to pay attention to the general context and the market their fund is investing in, when assessing it on the basis of its risk and performance data.

"I wouldn't necessarily screen out managers because their Sharpe ratio is not above one, for example, there needs to be more context," says Mr Lucar. "I try to use my statistics alongside a qualitative process, to tell me generally what's happening in the fund and then I can dig further."

Jason Hollands, managing director of Tilney Bestinvest, uses volatility measures such as the Sharpe ratio and standard deviation when screening for funds. Nevertheless, he says it's important to take them with a pinch of salt.

"There are a number of different ways you can measure risk and there's no single perfect benchmark to do so," he explains. "If a fund we're looking at has that precious attribute of consistent outperformance and less volatility than the index, then that for me is a real win win."

Funds with good risk/return profiles

Mr Hollands highlights JO Hambro UK Opportunities (GB00B95HP811), Threadneedle UK Equity Income (GB00B8169Q14) and Liontrust Special Situations (GB00B57H4F11) as examples of funds that have achieved good outperformance with less volatility.

"On a three-year annualised basis, Jo Hambro UK Opportunities has a volatility of 8.5 per cent, which is lower than the FTSE All-Share's 9.3 per cent, but it has beaten the index by 9 per cent in that time," he says. "The fund has about 20 per cent in cash and invests in high quality, cash-generative businesses, which tend to be larger companies. The manager has a strong emphasis on watching the downside, but has still managed to beat the market.

"Liontrust Special Situations invests quite heavily in small- and mid-cap companies, so you might assume that it is a riskier fund - but if you look at its volatility on a three-year annualised basis, it is 9.5 per cent compared with 9.3 per cent for the FTSE All-Share, and the fund has outperformed the market by 15 per cent in that time."

Liontrust Special Situations also has a particularly good risk/reward profile. Mr McDermott's analysis found that over five years the fund has a Sharpe ratio of 1.20 compared with the Investment Association (IA) UK All Companies sector average of 0.69. It also has a maximum drawdown of 9.49 per cent compared with 16.18 per cent for its sector.

Schroder Asian Income Fund (GB00B559X853) has a Sharpe ratio of 0.72 compared to the IA Asia-Pacific ex Japan sector average of 0.48. It also has a maximum drawdown of 18.99 per cent compared with 24.54 per cent for its sector average.

Mr McDermott also mentions Hermes US Smid Equity Fund (IE00B8JBCY79), which has a Sharpe ratio of 1.26 compared with 1.14 for the IA North American Smaller Companies sector average, over the past four years.

Mr Lucar, who specialises in analysing fixed-income funds, picks out three that have good all-round scores for standard deviation, Sharpe ratio and maximum drawdown over the past five years. Jupiter Strategic Bond (GB00B4T6SD53) has a standard deviation of 3.31 per cent, a Sharpe ratio of 2.16 and a maximum drawdown of 2.76 per cent. Rathbone Strategic Bond (GB00B6ZS2486) has a standard deviation of 3.22 per cent, a Sharpe ratio of 1.86 and a maximum drawdown of 3.22 per cent. Newton Global Dynamic Bond Fund (GB00B8H50V47) has a standard deviation of 2.28 per cent, a Sharpe ratio of 1.68 and a maximum drawdown of 2.67 per cent.

Funds' performance

Source: Morningstar, as at 25/11/16

*Performance is for a different share class to that mentioned in the text