Consistent Risk, Inconsistent Returns | Chief Investment Officer

Past performance may be no guide to future returns, but past volatility can be a guide to future volatility, research has shown.

“Market participants may not want to assume that higher aggressiveness must prove rewarding.”Investors can “sensibly manage” the volatility of their portfolios through reference to a fund’s historic volatility, reported Tim Edwards and Craig Lazzara of S&P Dow Jones’ index investment strategy group, and Luca Ramotti of the ESCP Europe business school.

The researchers analyzed active unleveraged funds in the US and Europe between 2005 and 2015, and found that the percentage of active funds with higher volatility than their benchmarks had increased since 2010 after declining over the previous two years.

Analysis of volatility over rolling two-year periods showed a high level of consistency among active funds, the researchers said.

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“For example, 70% of US-domiciled funds in the least volatile quintile in a given two-year period are in the two lowest volatility quintiles in the subsequent two-year period,” Edwards, Lazzara, and Ramotti wrote. Two thirds—66%—of the most volatile funds stay in the first or second most volatile quintiles, they added.

“Past performance may not predict future returns, but past volatility was a meaningful guide to the future volatility of active funds,” they stated.

On top of the volatility research, the authors also assessed returns in order to determine correlations between risk and return. At the outset of this exercise, the researchers said they expected lower-volatility funds “with persistently higher cash allocations” to underperform US equities, which gained roughly 8% annually.

“In fact, the data would appear to support a conjecture that, within any given fund category, fund volatility is effectively independent of fund return,” Edwards, Lazzara, and Ramotti reported. “The performance of different funds in the same category did not noticeably rise commensurately with their relative risk profile in the sample.”

In other words, while volatility usually remains consistent for active strategies, increasing overall risk levels will not automatically raise returns—nor will lowering risk necessarily decrease returns.

“Market participants may not want to assume that higher aggressiveness must prove rewarding,” the researchers concluded.

Fund volatility research

Read the full report, “The Volatility of Active Management.”

More frequent trading could boost returns—at least for the right fund size.

Although research has shown that high-frequency trading detracts from retail investor performance, some institutional investors actually outperform as a result of active trading, according to finance professors Jeffrey Busse (Emory University), Lin Tong (Fordham University), Qing Tong, and Zhe Zhang (Singapore Management University).

“Skillful trade execution can enhance an investment fund’s return relative to the competition,” they wrote. “Active trading has the potential to generate alpha if it can take advantage of opportunities in the securities markets.”

But lack of skill, the authors warned, could result in “excessive transaction costs and lagging performance. Only traders with skill can afford to bear the transaction costs associated with active trading.”

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For the study, the researchers examined the performance, transaction costs, and trading frequency of asset managers and asset owners from 1999 to 2009 using data from trading cost analyst Ancerno.

Frequent trading among institutional investors, they found, was tied to higher risk-adjusted returns net of transaction costs: The highest-frequency traders outperformed the most static group by 0.73%.

However, this gap narrowed as funds grew larger and generated higher transaction costs.

“Given that larger funds trade larger orders, they are susceptible to greater price impact from their trades,” the researchers explained. “Larger funds consequently realize lower net returns when they attempt to exploit short-term trading opportunities.”

Perhaps due to these higher costs, Busse, Tong, Tong, and Zhang found that larger funds exhibited lower trading frequency than their smaller peers.

“While it is difficult to argue with the idea that expenses should be minimized,” they concluded, “our evidence suggests that more expensive strategies can sometimes dominate, insofar as the most active institutional traders persistently produce positive abnormal returns.”

Read the full report, “Trading Frequency and Fund Performance.”