Risk vs. reward in mutual funds

Nation's Business, Dec, 1996 by Randy Myers

True or false: To achieve higher rewards in your mutual-fund portfolio, you have to be willing to take higher risks.

If you answered true, congratulations. You're in good company. The principle of equating higher risk with higher reward is a fundamental tenet of virtually every investment book.

If you answered false, well, don't tuck your tail yet. It may be that you've pulled your head out of the textbooks long enough to take a look at how things work in the real world, where the relationship between risk and reward is a whole lot fuzzier than it is in the textbooks.

Sure, the risk-reward principle holds water at the macro level. Stock returns historically have been more volatile than those for bonds, but they have also been consistently higher. And bonds are clearly riskier than cash in the sense that bonds, unlike cash, can go up or down in price.

But look what happens when you start to divide mutual funds into categories that are presumed to reflect their risk-reward profiles. Among domestic stock funds, almost everybody would agree that the riskiest types of funds are aggressivegrowth funds--those that buy stocks strictly because they're expected to appreciate rapidly in value. At the opposite end of the spectrum are equity-income funds, designed to provide high current income through stock dividends.

Unexpected Results

Behaving by the book, aggressive-growth funds were considerably more volatile than equity-income funds for the 10 years that ended Aug. 31, and the former also outperformed the latter by nearly 2 percentage points per year during that period, according to data supplied by Morningstar Inc., a mutual-fired research company in Chicago.

Over the past 15 years, however, the average equity-income fund has outperformed the average aggressive-growth fund by nearly 2 percentage points, a complete reversal of what conventional wisdom would lead one to expect.

Even among funds with the same investment objectives, risk and reward don't always follow the expected pattern. Fairmont Fund and Longleaf Partners Fund are both high-performing growth funds whose returns were in the top quartile among their peers for the five-year period that ended Aug. 31; average annualized returns were 15.2 percent and 17.9 percent, respectively.

Yet by one popular risk measure, Longleaf achieved its higher return with lower risk. Its standard deviation (a measure of how widely dispersed its monthly returns have been over a specified period) was approximately half that of Fairmont. Clearly, the investor who suffered through bigger ups and downs with Fairmont over those five years was not rewarded with better performance.

Difficulties Of Discovery

As if it weren't bad enough that the relationship between risk and reward can be so tenuous, finding out just how risky any mutual fund is can be difficult. Daily newspapers--even The Wall Street Journal--don't carry the data, and most fund companies don't disclose it in their prospectuses.

That could change, however, if the Securities and Exchange Commission proceeds with a proposal to require disclosure. It floated that idea nearly two years ago but has yet to take any formal action. Part of the problem is that there are many ways to measure risk, and most fired experts agree that no single number would be adequate.

Nonetheless, there are ways to learn about how risky your mutual funds---or any that you're considering buying--have been. Morningstar Reports and the Value Line Mutual Fund Survey both publish risk data; you can subscribe to them or find them in many public libraries. Also, personal-finance magazines publish special mutual-fired issues in which they list at least one if not several risk measures.

When doing your research, avoid the temptation to focus exclusively on one measure. Instead, try to look at all the measures you can find; each has different strengths and shortcomings. Here are a few of the most popular:

Beta. Beta measures a fund's sensitivity to the movement of the overall stock market, usually represented by the Standard & Poor's 500-stock index.

A fund with a beta of 1.0 should mirror the index's movements. A fund with a beta of 1.1 should move 10 percent higher than the index in up markets, and 10 percent lower in down markets. A fund with a beta of 0.9 should move 10 percent less than the index in either direction.

The problem with beta is that it's useful only if the fund has a high R-Squared figure, which leads us to our next measure.

R-Squared. This measures the percentage of a fund's movements resulting from movements in the overall market, again usually represented by the S&P 500. An R-squared of 100 percent indicates that the fund mirrors the market. An R-squared of 50 percent means that only 50 percent of its movement is tied to the performance of the market. The lower a fund's R-squared percentage, the less reliable its beta.

Standard Deviation. This measures the extent to which a fund's returns varied over a specified time. The higher the number, the higher the fund's volatility.