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Is Your Fund Taking Too Much Risk?

The credit crunch has hurt lately, but keep the big picture in mind, too.

David Kathman, CFA., 14 February, 2008 | 11:45AM
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Many funds have suffered big losses amid the global credit crunch. Such blowups highlight the risks that come with investing. Identifying those risks, and 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. Here are some of the most useful ways to look at mutual fund risk.

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. (You can find more about the details of our methodology in this document, and you can find any fund's three-year standard deviation on its Risk Measures page on Morningstar.co.uk.)

One problem with standard deviation is that it's essentially meaningless without a 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 31 January, the highest five-year standard deviation in the Morningstar Sterling Money Market category belonged Lloyds TSB Money Fund Man GBP at 0.77%. In contrast, the fund with the lowest standard deviation in the Morningstar Sector Equity Precious Metals category was Investec GSF Global Gold, at 26.58%--more than 34 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 the measure uses a "utility function" that penalizes downside variation more than it rewards upside variation. (Finance whizzes can read all about it in this document.) Each fund's Morningstar Rating page on Morningstar.com 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 Investec GSF Global Gold shows that its five-year Morningstar Risk is below average for its category, eve though (as we saw above) its standard deviation for the same period 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. Such funds can be quite streaky and may often rank near either the top or the bottom of their peer groups.

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. Prudential Ethical Trust, for example, had roughly 40% of its equity assets in financial services stocks recently. Needless to say, it fared poorly over the back half of 2007 as a result.

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 in recent years, and funds with a lot of emerging-markets exposure have done very well. Neptune Global Equity, for example, has compiled one of the best records in the Morningstar Global Large-Cap Growth Equity category over the past five years, and one of the reasons has been its outsized weighting in emerging markets stocks, which stood at roughly 37% of equities at the end of 2007. That exposure has also made this one of the category's most volatile options and hurt the fund temporarily in 2006 when emerging markets tumbled in the spring, and more recently as emerging markets crumbled in January 2008.

Market cap risk is also well worth noting. Because of the overly broad construction of the IMA's UK All Companies peer group, many managers have loaded up on mid-caps to stay near the top of that sector's ranks in recent years. That decision hurt many funds badly in 2007 as investors flocked to the perceived safety of large caps. Whilst there can be greater inefficiencies for managers to exploit among small- and mid-cap issues, the business-risk tends to be considerably higher, and liquidity issues can exacerbate difficult situations.

These examples have all involved equity funds, but bond funds feature similar portfolio-based risks. Until the subprime-mortgage crisis hit, high-yield bonds were on a great multiyear run and bond funds with a lot of high-yield exposure relative to their peers generally did very well. While those great recent 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. The risk of new or higher fees is also worth considering, and here, too, some fund shops are much better than others--New Star's funds tend to be relatively expensive on a TER basis, for example.

Asset bloat is another operational risk to consider; if a fund's asset base gets too big, it becomes harder to beat a benchmark or a peer group. This is especially risky for funds focused on smaller-cap or less liquid issues, where a manager may be forced to buy more of a stock than he s comfortable owning to build a meaningful position, or spread the fund's assets across an increasingly large number of names.

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.co.uk and go to the tabs on the left side of the page. As we saw earlier, under the Risk and Rating tab you'll find the fund's Morningstar Risk over the trailing three, five, and 10 years, and 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 Report (under the Analyst Research tab), which will generally discuss any significant risks to look out for. We're rapidly growing our library of reports, so do check back frequently.

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 Instant X-Ray tool on Morningstar.co.uk can break down a portfolio by sectors and asset classes, and registered members can use the Portfolio X-Ray to get a more detailed analysis. 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.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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