Less Volatile Funds Tend to Perform Better

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.