Funds that beat the index with lower volatility

The best-performing Investment Association (IA) UK Equity Income sector fund was Threadneedle UK Equity Alpha (GB00B88P6D76), which made a cumulative total return of 91.2 per cent over five years to the end of September 2016, against 68.9 per cent for the FTSE All-Share. It also had lower volatility of 10.3 per cent compared with 10.4 per cent for the index.

In the UK All Companies sector, funds which beat the FTSE All Share with lower volatility include Evenlode Income (GB00B40Y5R17). The fund invests in quality companies with strong brands and high customer loyalty, meaning their returns tend to be more consistent. Jason Hollands, managing director at Tilney Bestinvest, said: "[Evenlode] focuses on businesses that are cash compounders with little drag from owning fixed assets (such as machinery and plant)."

A focus on attributes such as high barriers to entry, and capital-light businesses able to command pricing power and a high return on equity, helped some of the index-beating UK funds keep volatility down, added Mr Hollands.

A number of European and Asian equity funds have also beaten the main benchmarks for these regions with lower annualised volatility. These include Marlborough European Multi-Cap (GB00B90VHJ34), which achieved the best margin of outperformance with the lowest risk, returning 124.1 per cent over five years with annualised volatility of 11.9 per cent, compared with the FTSE World Europe ex-UK index which returned 83.6 per cent with annualised volatility of 13 per cent.

However, although a number of UK smaller companies funds beat the FTSE Small-Cap index, none of them did this with lower volatility. But Darius McDermott, managing director of Chelsea Financial Services, explained that smaller companies funds are generally more volatile than those invested in large-caps due to the illiquid nature of their holdings, which are at an earlier growth stage, making their share price more vulnerable to dramatic spikes following good or bad news.

"In some of the larger-cap areas there are genuinely low-beta stocks," said Mr McDermott. "If that is your style and you are looking for quality companies with good cash generation that are less volatile, you can find those [among large-caps] and maintain lower volatility than an index. With small-caps, it doesn't matter if it's a quality business - a profit warning can send the share price down 40 per cent very quickly because of the illiquidity premium."

Most smaller companies funds also have far fewer stocks than the FTSE Small-Cap index, which could be another reason for their higher volatility relative to this index, he added. But when it comes to other risk metrics, many small-cap funds perform well and their outperformance has been far greater than large-caps.

Standard deviation can mean dramatic upward movement in prices as well, and over five years 24 IA Smaller Companies funds have outperformed the FTSE Small-Cap index. The best performer, River & Mercantile UK Equity Smaller Companies (GB00BC4DSV56), has outperformed the FTSE Small-Cap by a greater margin than the best-performing UK All Companies fund compared with its benchmark.

Benchmark-beating funds with lower volatility

Source: Tilney Bestinvest, as at 30.09.16