Is your mutual fund taking too much risk?

Investing tip of the month from Morningstar Investment Research Center by David Kathman, Fund Analyst.

In 2008, many investors felt like they had nowhere to hide. Investment types that many investors thought might offer shelter during inclement weather for the stock market--such as bond funds and commodities--posted painful losses. Such blowups highlight the facts that investing comes with risks and that some investments are riskier than others. Identifying those risks, in addition to figuring out how much you're willing to tolerate, is one of the most important aspects of long-term investing.

Unfortunately, there's no single definition of risk that works for everybody, but there are some key measures that will usually give you a good approximation. They're not perfect--there are often hidden risks lurking--but they're certainly better than guesswork.

Backward-Looking Risk Measures
The world of finance is replete with measures that try to gauge how risky an investment has been in the past. In this context, risk is often equated with volatility, and the most common way to measure the volatility of a mutual fund (or any portfolio) is standard deviation. As Morningstar calculates it, this measures how widely the fund's monthly returns have varied over some period of time, usually three, five, or 10 years. If monthly returns have been very consistent, the standard deviation will be low, while if they have been all over the map, the standard deviation will be high.

One problem with standard deviation is that it doesn't have a lot of meaning without some context. Some types of funds are inherently more volatile than others, so any given fund's standard deviation can only be reasonably compared with those of its peers. Sector funds are more volatile than diversified stock funds, which in turn are more volatile than bond funds, and within each of these broad groups there's a lot of variation. As of June 30, the highest five-year standard deviation in the short government bond category belonged to Oppenheimer Limited-Term Government (OPGVX) at 3.54. In contrast, the specialty precious-metals fund with the lowest standard deviation was First Eagle Gold (SGGDX) at 30.47--nearly 10 times as much.

Another potential problem with standard deviation is that it treats big gains and big losses (in industry parlance, upside and downside volatility) the same. But most investors are a lot more concerned with downside volatility--the possibility that a fund will lose money or greatly underperform its peers. One measure that takes this difference into account is the Morningstar Risk score, which is part of the Morningstar Risk-Adjusted Return that helps determine a fund's Morningstar Rating. The details are rather complicated, but basically this measure uses a "utility function" that penalizes downside variation more than it rewards upside variation. Each fund's Morningstar Ratings & Risk page on Morningstar Investment Research Center shows its Morningstar Risk relative to its category, ranging from "high" (the riskiest 10%) down to "low" (the least risky 10%). For example, the page for First Eagle Gold shows that its Morningstar Risk is among the lowest in its category, even though (as we saw above) its standard deviation is high in absolute terms. The fund has shown a lot of variation in its returns but has done a better job than its peers of avoiding big losses.

Portfolio Risks
Both standard deviation and Morningstar Risk are backward-looking risk measures--that is, they're based on how a fund has performed in the past. That can certainly be useful, but most investors (and potential investors) are more interested in what a fund is likely to do going forward. Obviously we can't know for sure how a fund will perform in the future, but it's still possible to look at its strategy and current portfolio and get some idea of what kinds of potential risks a fund is likely to face.

One factor to keep an eye on is concentration. Funds that concentrate their assets in relatively few holdings--say, fewer than 30 for stock funds--can suffer in the short term if just one or two of those holdings run into problems. Such concentration risk is separate from standard deviation and Morningstar Risk, and it's often present in funds that we like quite a bit. For example, the Jensen Fund (JENSX) has compiled a very good long-term record with a concentrated portfolio of about 25 stocks. Its standard deviation and Morningstar Risk are very low because of the managers' long-term focus, but its concentrated nature has made performance quite streaky, so that it has typically ranked near either the top or the bottom of the large-growth category.

A related type of risk arises from sector concentration, especially when these are volatile sectors such as technology. The most obvious example of this is sector funds, which focus on a single sector, but there are also quite a few funds that are nominally diversified but still pile into one or two sectors that can wreak havoc with returns. An extreme example of this is White Oak Select Growth (WOGSX), a large-growth fund that has about half of its portfolio in technology stocks. That huge tech stake led the fund to an eye-popping return streak in the late 1990s, but this was followed by ugly double-digit losses in 2001 and 2002. It rebounded in 2003, only to lose big again after that. Predictably, it's on top again so far in 2009, thanks to tech stocks' great showing so far this year.

Yet another type of risk to watch out for in stock funds is country or geographical concentration, especially concentration in relatively risky areas such as emerging markets. Emerging-markets stocks have been red-hot for the better part of this decade, and funds with a lot of emerging-markets exposure have done very well. Janus Contrarian (JSVAX), for example, has compiled one of the large-blend category's best records over the past five years, and one of the reasons has been its outsized weighting in foreign stocks, including, at times, significant exposure to India and other emerging markets. That exposure has also made this one of the category's most volatile options and hurt the fund badly in 2009, when emerging markets tumbled. It's still a pretty good fund overall, but it could take a hit if and when overseas stocks end their run of outperformance.

These examples have all involved equity funds, but bond funds feature similar portfolio-based risks. Until the subprime-mortgage crisis hit, high-yield bonds and emerging-markets bonds were on a great multiyear run, much like emerging-markets stocks, and bond funds with a lot of high-yield exposure relative to their peers generally did very well. Within the intermediate-term bond category, for example, the best-performing funds from 2003 through 2006 were mostly those with lots of exposure to such risky bonds, such as Federated Bond (ISHIX). While those great returns may have looked attractive and even benign at first glance, there was plenty of risk lurking in those portfolios, as the subprime mess illustrated all too clearly.

Operational Risks
Another group of risks worth touching on for mutual fund investors are operational risks, which have to do with how a fund is run. For example, the risk that a manager might leave a fund is certainly something to consider, and that risk is much higher in some cases than in others. Fidelity sector funds are well-known for high manager turnover (though they've gotten better recently), while shops such as Dodge & Cox and Longleaf have managers who have been in place for decades. The risk of new or higher fees is also worth considering, and here, too, some fund shops are much better than others--Vanguard is well-known for keeping expenses low, while Gabelli, to give one example, is not.

What You Can Do
There are a number of ways that you can check the funds in your portfolio (or those you're thinking of buying) for these various types of risk. Look up any fund on Morningstar.com and go to the tabs at the top of the page. As we saw earlier, under the Morningstar Ratings & Risk tab you'll find the fund's Morningstar Risk over the trailing three, five, and 10 years, and the Risk Measures tab will show you its standard deviation, along with some other measures that we haven't discussed here, such as the Sharpe ratio.

For the forward-looking risks, click on the Portfolio tab and scroll down to the sector weightings, where you can see whether the fund is over- or underweight in various sectors relative to its category peers. It's always a good idea to look at the Analyst Reports on Morningstar Investment Research Center (under the Analyst Research tab), which will generally discuss any significant risks to look out for. Our Stewardship Grades can also give you an idea of a fund's operational risks, especially in the corporate-culture section.

In all this, it's important to remember that no fund's risk should be looked at in isolation. A fund that might look very risky all by itself could be a good fit in certain portfolios. For example, a fund with lots of technology holdings could complement a portfolio with heavy value leanings, and an emerging-markets fund could help diversify a portfolio consisting entirely of domestic stocks. The Portfolio X-Ray tool on Morningstar Investment Research Center can break down a portfolio by sectors and asset classes. You might find that you're taking on risks that you didn't realize, such as a big weighting in technology stocks, or you might find that there's room in your portfolio for more risk. When all is said and done, it's important to remember that even the best fund managers can have streaky short-term performance, so it's best not to get too hung up on consistency.

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