Investors in smaller companies have experienced broadly better risk-reward profiles than those invested in their large-cap peers over the last decade, according to data from FE Analytics.
In the first article of a new study, FE Trustnet uses scatter charts to map the risk-adjusted returns of all sectors in the Investment Association (IA) universe.
While higher volatility strategies are typically understood to have the potential for larger future returns they also come with a higher possibility of making losses.
This may hold up in theory, but as the below chart shows, the practice is somewhat different. The left-hand side of the chart fits this mould well, however more volatile sectors have largely been more variable than the theory may suggest.
The chart below shows the return and volatility of every single IA sector over the past decade with the x-axis measuring volatility while the y-axis measures total return.
This enables investors to compare funds on a risk-adjusted return basis – a phenomenon that has grown more important in recent years as investors weigh-up whether to take on more risk the further into the post-crisis bull market we get.
Scatter chart of sectors’ risk-adjusted returns over 10yrs
Source: FE Analytics
As such, the best fund sector for risk-adjusted returns over the past decade, according to data from FE Analytics, has been IA Technology & Telecommunications.
This is largely unsurprising as the rise of technology stocks has been a major theme in equity markets – particularly in the US where large names including Facebook, Apple, Amazon, Netflix and Google (also known as the FAANGs) have led the market.
Technological innovation and the pace in the growth of low-cost, asset-lite internet businesses has been one of the key themes for much of the post-crisis era.
Overall the sector has returned 317.77 per cent over the past decade with volatility of 17.78 per cent and a Sharpe ratio – which is a measure of risk-adjusted returns – of 0.8.
Outside of the tech sector, however, four of the next five sectors are focused on small-caps, with the IA Japanese Smaller Companies the next best.
The sector has returned 304.44 per cent with volatility of 15.63 per cent and a Sharpe ratio of 0.74. It is the most improved sector from when we conducted this study a year ago, with returns up 123.07 percentage points compared with the period of 2007-2017.
Since 2008, the Japanese smaller companies have been in the top quartile of sectors in six calendar years, and was the third-best overall in 2017.
Japan has been a popular pick for the last couple of years as investors have backed economic reforms set in motion by prime minister Shinzo Abe – also known as ‘Abenomics’.
Smaller companies typically should have a better risk-adjusted return than their large-cap peers as they invest in companies with a higher propensity for growth.
However, these companies are also more likely to run into balance sheet problems and can therefore be riskier.
Table of best sectors for risk-adjusted return over 10yrs
Source: FE Analytics
Over the last decade though, with investors desperate to find growth in a low-growth world, smaller companies have emerged as the place to be invested.
Indeed, IA UK Smaller Companies is the fourth-best sector for Sharpe ratio (0.64), with returns of 234 per cent while experiencing volatility of 14.61 per cent.
Similarly, the IA European Smaller Companies sector is next with investors receiving 200 per cent in total returns on volatility of 17.18 per cent and a Sharpe ratio of 0.47.
All of these sit above their large-cap peers, with the exception of one market: the US.
As mentioned previously, the market has been defined by the rise of technology names with four of the top five companies in the index residing in the sector.
This is due to their phenomenal growth, which has been coupled with ‘momentum’ investors buying into these companies. Latterly, it could also be that passive investors are buying into the same stocks – boosting the underlying share prices.
With this in mind, it should be of little surprise that the IA North America sector has been the second-best in the IA universe for risk-adjusted returns. It has made investors 224 per cent with volatility of 13.62 per cent and a Sharpe ratio of 0.74.
The IA North American Smaller Companies sector has actually outpaced its large-cap peers, returning 275 per cent. However, it has been a lot more volatile (16.43 per cent), giving it a Sharpe ratio of 0.65.
Of the other major equity sectors, the IA Global Emerging Markets sector is the exception to the rule that higher risk equates to better returns.
Indeed, the sector has returned 77.95 per cent over the last decade, with volatility of 18.35 per cent, giving it a Sharpe ratio of just 0.13.
The sector has had a rougher time than developed markets over the past decade as many commodity-dependant countries were hit by the cycle crashing between 2010 and 2015.
Performance of indices over 10yrs
Source: FE Analytics
Additionally, China – which dominates the market – took a tumble in 2015 as the government devalued its currency, causing concerns over its growth potential moving forward.
Of the non-equity sectors, the best for risk-adjusted returns over the past decade has been the IA UK Index Linked Gilts sector, which has on average returned 95.43 per cent with volatility of 9.91 per cent for a Sharpe ratio of 0.35.
With interest rates at or near historic lows during the period bonds have outperformed, with yields steadily contracting for much of the past decade.
Index-linked bonds were also en vogue in the UK in 2016 as inflation went above 3 per cent, with many concerned that this could lead to quicker interest rate rises from the Bank of England.
On a broader view, IA Global Bonds is the next-best non-equity sector for risk-adjusted returns, with a Sharpe ratio of 0.33. It has returned 73.79 per cent with volatility of 6.62 per cent.