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Course 204
Looking at Historical Risk, Part 2


Until now, we've focused on risk measurements that you can find on most Web sites or in print publications. In this lesson, we'll discuss some only-from-Morningstar yardsticks you can use to get a handle on a fund's risk.

Why does Morningstar offer its own risk statistics when standard deviation and beta already exist as reliable statistics? Those figures give you an idea of how risky a fund is on an absolute level and as compared with an index. But as we pointed out in our last session, no single risk measurement can give you a full idea of a fund's volatility. If you approach risk from various angles—as Morningstar's measures do—you can get a much better picture of how a fund should behave. You can find all of these measures in a Morningstar fund report.

Morningstar Risk

Morningstar Risk score describes the variation in a fund's month-to-month returns. But unlike standard deviation, which treats upside and downside variability equally, the risk score places greater emphasis on downward variation, or losses.

The theoretical foundation for Morningstar Risk (and Morningstar's risk-adjusted return measure, also called the star rating) is relatively straightforward: The typical investor is risk-averse. Morningstar adjusts for risk by calculating a risk penalty for each fund based on that risk aversion. The risk penalty is the difference between a fund's raw return and its risk-adjusted return based on "expected utility theory," a commonly used method of economic analysis. Although the math is complex, the assumption is that investors prefer higher returns to lower returns, and—more importantly—prefer a more certain outcome to a less certain outcome. In other words, investors are willing to forego a small portion of a fund's expected return in exchange for greater certainty. Essentially, the theory rests on the assumption that investors are more concerned about a probable loss than an unexpectedly high gain.

Like beta, Morningstar's risk score is a relative measure. It compares the risk of funds in each Morningstar category. For example, a fund in the large-cap growth category is compared only with other funds in the same category. Likewise, a municipal-national short-term fund is compared only with offerings in the same category. This apples-to-apples comparison allows investors to evaluate the historical risk of funds that are likely to be considered for the same role in a broader portfolio.

Within each category, we rank each fund's risk penalty—the difference between its raw and risk-adjusted returns—from highest to lowest. A fund with greater variation in its month-to-month returns would be assessed a larger penalty than a fund with lesser variation. The level of risk is assigned based on the ranking for funds in the category: The top 10% of funds are High risk, the next 22.5% are Above Average risk, the middle 35% are Average risk, the next 22.5% are Below Average risk, and the bottom 10% are Low risk.

When using Morningstar Risk, remember that we set a fund's score based on its risk level relative to its category peers. You can't compare the Morningstar Risk score of funds from different categories, as you can their standard deviations. For example, an intermediate-term bond fund with High Morningstar Risk may be more volatile than other intermediate-term bond funds, but it could be—and, due to the nature of stock funds, probably is—less risky than a small-cap value fund with Below Average Morningstar Risk.

Bear-Market Rankings

Bear-market rankings compare how funds have held up during market downturns over the past five years. This measure is unlike the others presented thus far, because it examines performance only during the times in which investors may face the largest potential for losses—during downturns, or corrections, in the market.

A bear market is officially defined as a sustained market correction, but for the purpose of these rankings, Morningstar identifies "bear-market months" that have occurred in the past five years. For stock funds, we consider any month in which the S&P 500 Index lost more than 3% to be a bear-market month. For bond funds, we count any month in which the Barclays Aggregate Bond Index lost more than 1%.

To generate our current bear-market rankings, we simply total each fund's performance during bear-market months over the past five years and separate them into percentiles. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. The top-performing fund in a category will always receive a rank of 1. These scores can help predict which funds will hold up well should the market undergo another correction.

Bear-market rankings have two major drawbacks. First, these measures let you know how a fund performed only during certain time periods. Although it's helpful to know how your fund performed during these market downturns, the fund could certainly lose money—lots of it—during a market upturn, too. Gold funds, for instance, often earn decent bear-market ranks, but they lose money at other times and are not considered low-risk investments.

The second drawback to bear-market rankings is that not all bear markets are the same. The next market correction may be caused by different economic forces than those that led to the previous one. Hence, funds that held up well in one bear market may not do so well in the next. Conversely, funds that were pummeled the last time around might shine in the next bear market.

All of the risk measurements we've discussed are based solely on past performance. By definition, they fail to account for any future risks a fund might harbor. For example, a fund that used to own mostly low-key large-company stocks may now be heavily invested in smaller companies, and therefore it may be taking on more risk than its historical measures show. Given this limitation, remember that statistical risk measures are a good way to begin understanding a fund's risk, but they're not guarantees of safety.

Quiz 204
There is only one correct answer to each question.

1 Morningstar Risk measures how volatile funds are:
a. Relative to an index.
b. Relative to others in its category.
c. During market corrections.
2 If you want to compare how volatile a bond fund and a stock fund are, use:
a. Morningstar Risk.
b. Morningstar's bear-market rankings.
c. Standard deviation.
3 What's the best way to use bear-market rankings?
a. To find funds that don't exhibit wild performance swings.
b. To find funds that tend to do relatively well when the market falls.
c. To find funds that will definitely do well in the next bear market.
4 Morningstar Risk is based on the idea that investors are more concerned about:
a. Unexpectedly high gains.
b. The chance of losing money.
c. Maximizing uncertainty.
5 Morningstar Risk describes the variation in a fund's:
a. Annual returns.
b. Daily returns.
c. Monthly returns.
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