July 6, 2004 — Funds with less volatile returns have generally outperformed those with medium to high volatility over the past three years. A few styles had better results with high-risk funds, but low volatility generally offered better results.

A well-known rule of finance is that higher risk offers potentially higher returns. How often does that higher risk translate into better results in the mutual-fund world? To find out, we looked at three-year standard deviation, a measure of a volatility, and compared that with three-year returns through May. Our study covered 4,464 funds of varying volatility in all nine style categories in Standard & Poor’s database, and included multiple-share classes.

We broke down each style category into three groups based on volatility, from lowest to highest. We determined the range for the low-, medium- and high-volatility groups by subtracting the lowest fund volatility in the style category from the highest and dividing by three.

In six of the nine styles, the funds in the lowest volatility group easily posted the best average performance. The other three styles saw just the opposite result, with the highest risk group posting the best average performance. These three styles were large-cap value, mid-cap value and mid-cap blend. However, while the highest volatility funds were the best performers in these three cases, in two of them these funds represented only a very small percentage of all the funds in the particular style. In large-cap value and mid-cap blend, only about 2% of the funds were in the high-risk group. The results are in Table 1 below.

Two of the three styles in which high-risk funds performed the best were mid cap: value and blend. In addition, two of these three styles were value: large cap and mid cap. Meanwhile, growth was the only group in which low-risk funds were the best performers across all three capitalizations.

However, even though low volatility won in all three growth capitalizations, these funds as a group still suffered losses. The average return was negative for low-, medium- and high-risk funds in large-, mid- and small-cap growth. This was not entirely surprising for large-cap growth, given that the S&P 500/Barra Growth index posted an annualized loss of 2.1% over the past three years. The decline for mid- and small-caps, however, was more troubling given that the S&P MidCap 400/Barra Growth and the S&P SmallCap 600/Barra Growth indexes both rose during the same period.

None of the nine styles saw the mid-range volatility group provide the best returns, indicating that investors are better off sticking to high-volatility or low-volatility funds. Attempting to straddle the midpoint between high and low risk, hoping to benefit from some volatility without having too much, doesn’t appear to be a good strategy.

The vast majority of funds in our study fell into either the low- or medium-risk categories. In all nine styles, those with high volatility represented by far the lowest percentage of funds. Growth and blend funds across all three capitalizations generally had the largest majority of funds in the lowest volatility groups. The percentage of funds in the lowest volatility range varied from 73% for mid-cap growth to 95% for large-cap growth. Conversely, value funds in all three capitalizations overall tended to have more funds in the mid-volatility category. The percentage of value funds in the mid-range of volatility varied from 31% for small-cap value to 66% for large-cap value.

In terms of the range of volatility, almost all the styles had a range of about 20% to 30% from the bottom of the lowest category to the top of the highest. However, large-cap growth funds had by far the largest variation in risk. The volatility from the low end of 8.3% to the high end of 64.5% represented a staggering range of 56.25%. Another growth style, small cap, had the next highest range at 38.70%, while all other styles were well below that range.

We selected one fund from each of the six style categories in which low-volatility funds performed the best. We made our selections based on the combination of the best three-year return along with the lowest volatility. These funds are listed in Table 2 below.

Table 1

Fund Style/Volatility Ranges

3-Year Standard Deviation

3-Year Returns

Funds in Category

Percentage of Funds in Category

Large-Cap Growth

8.25% – 27.00%

17.50%

-5.77%

982

95.2%

27.01% – 45.75%

32.92%

-9.57%

41

4.0%

45.76% – 64.50%

64.06%

-23.02%

8

0.8%

Style Total

18.47%

-6.06%

1031

100.0%

Large-Cap Blend

9.00% – 18.75%

15.90%

-2.91%

710

91.4%

18.76% – 28.50%

21.25%

-4.49%

55

7.1%

28.51% – 38.50%

34.76%

-10.93%

12

1.5%

Style Total

16.57%

-3.14%

777

100.0%

Large-Cap Value

8.75% – 15.20%

13.84%

-0.38%

263

32.1%

15.21% – 21.65%

17.21%

-0.92%

537

65.5%

21.66% – 28.10%

23.80%

+1.24%

20

2.4%

Style Total

16.29%

-0.69%

820

100.0%

Mid-Cap Growth

13.10% – 22.45%

18.56%

-2.14%

341

73.2%

22.46% – 31.80%

25.19%

-7.37%

115

24.7%

31.81% – 41.15%

35.11%

-14.61%

10

2.1%

Style Total

20.55%

-3.70%

466

100.0%

Mid-Cap Blend

10.65% – 18.60%

16.12%

+4.99%

116

81.1%

18.61% – 26.55%

20.98%

+0.05%

24

16.8%

26.56% – 34.55%

32.31%

+6.87%

3

2.1%

Style Total

17.27%

+4.20%

143

100.0%

Mid-Cap Value

8.15% – 15.00%

12.77%

+6.78%

78

37.7%

15.01% – 21.85%

17.86%

+6.48%

99

47.8%

21.86% – 28.75%

25.52%

+10.54%

30

14.5%

Style Total

17.05%

+7.18%

207

100.0%

Small-Cap Growth

13.70% – 26.60%

21.49%

-0.75%

371

78.6%

26.61% – 39.50%

28.93%

-3.31%

94

19.9%

39.51% – 52.40%

45.75%

-20.65%

7

1.5%

Style Total

23.33%

-1.56%

472%

100.0%

Small-Cap Blend

12.50% – 22.25%

19.03%

+6.78%

199

92.6%

22.26% – 32.00%

23.29%

+6.04%

12

5.6%

32.01% – 41.75%

36.92%

+1.24%

4

1.9%

Style Total

19.60%

+6.64%

215

100.0%

Small-Cap Value

10.05% – 19.10%

16.51%

+10.66%

226

67.9%

19.11% – 28.15%

21.04%

+10.28%

103

30.9%

28.16% – 37.20%

31.77%

+7.83%

4

1.2%

Style Total

18.10%

+10.51%

333

100.0%

Table 2

Fund

Style

3-Year Returns

3-Year Standard Deviation

S&P Star Rank

Fidelity Contrafund (FCNTX) Large-Cap Growth

+4.44%

10.27%

5

AmSouth Select Equity/Instl (ASEPX) Large-Cap Blend

+8.68%

12.12%

5

Columbia Acorn Select Fund/Z (ACTWX) Mid-Cap Growth

+8.67%

13.57%

5

Hennessy Cornerstone Growth Fund (HFCGX) Small-Cap Growth

+11.63%

17.06%

5

Century Small Cap Select/Institutional (CSMCX) Small-Cap Blend

+16.62%

12.52%

5

Aegis Value Fund (AVALX) Small-Cap Value

+16.17%

10.91%

5

Source: Standard & Poor’s. Total returns include reinvested dividends. Data as of 5/28/04.

Contact Robert F. Keane with questions or comments at:

bkeane@ai-mag.com.