Grasping idea of 'risk-adjusted return' helps you manage mutual funds better


August 04, 1991|By WERNER RENBERG | WERNER RENBERG,1991, Werner Renberg

If you're the type who checked whether the latest gross national product increase was adjusted for inflation, you probably would also appreciate risk-adjusted rates of return for your mutual funds.

But even if you let others worry about how GNP figures are calculated, you ought to have a grasp of the concept of "risk-adjusted return."

The knowledge could help you to manage your mutual fund investments better.

You're aware that a fund's total return -- the most important measure of performance -- reflects the change in its share price during a given period, plus reinvested income and capital gains.

When you spot a fund with a high rate of return, though, you can't tell whether its portfolio manager is a good stock or bond picker, or whether he engages in risky investment practices to achieve short-run performance.

Thus, total return does not tell you whether a high-performing fund could be too risky for you.

Risk is related to the volatility of a fund's returns. When you sell, you're more likely to lose money in a highly volatile fund than in a less volatile fund. That's because there's a greater chance the share price of a highly volatile fund will be below what you paid.

Volatility, of course, does not imply that prices only drop. Prices also rise, and those of highly volatile funds should rise more.

You expect to be more richly rewarded for taking greater risk, and often returns for more volatile funds are higher indeed. It's only fair -- but, to be sure, not guaranteed.

The challenge for you is to stick to funds whose risk levels you can tolerate and whose returns are commensurate with their risk levels. This requires knowing not only return and volatility data, but also a way to link the two.

The best-known measure of the volatility of a fund's returns is called "beta." It compares a fund's volatility over a three-year period with the entire stock market, as represented by the Standard & Poor's 500 Index.

The index is assigned a beta of 1.0. A fund whose returns are 20 percent more volatile than the market's is said to have a beta of 1.20. One whose returns are 20 percent less volatile is said to have a beta of 0.80.

Given a fund's beta, you can check whether its rate of return is higher or lower than would have been expected. A fund with a beta of 1.10, for example, would be regarded as having done well if it had outperformed the index -- or market -- by 15 percent.

This technique can't be relied on to forecast a fund's performance -- in part because a fund's beta may change with market conditions. But it does indicate a fund's relative volatility.

Betas based on the S&P 500 aren't always meaningful, however.

As long as a beta is based on the index of 500 companies' stocks, it is irrelevant for funds invested in bonds. Since the 500 companies are larger U.S. ones, such a beta also is not very relevant to small-company growth funds or international funds. And since the index only captures market risk -- not the risks unique to different industries and companies -- it's also not very relevant to funds concentrated in single industries.

To capture market, industry, and company risks -- in other words, a fund's total risk -- analysts use another mathematical tool, standard deviation.

The tool, which measures how much a series of numbers varies from the average of the numbers, can show how much a fund's returns vary from their average over a period of time.

By comparing the standard deviations of funds you're considering, you see which involve the greatest total risk. By figuring the ratios of their returns to their standard deviations and comparing them, you see which are more likely to compensate you for accepting volatility.

The table -- reflecting data for the top 15 performers of the last three years -- illustrates what can happen to a group's rankings when total returns are adjusted for total risks.

Fidelity Select Medical Delivery, for example, which ranked third in performance with an average annual return of 37.6 percent, ranked eighth in risk-adjusted return because of its high total risk. Fidelity Select Food & Agriculture, on the other hand, the 14th performer at 23.7 percent, rose to fifth because of its lower total risk. (A number of other funds had higher total risk than the riskiest of this group, Twentieth Century Ultra. None of them equaled its 22.5 percent return, though, and five actually lost money for their investors.)

Some data services, such as CDA Investment Technologies (11501 Georgia Ave., Silver Spring, Md. 20902), publish funds' standard deviations quarterly, enabling you to adjust returns for total risk. But it's not necessary for you to do the work.

There are sources that rank funds by total risk-adjusted returns in easily understood terms. These sources include "The Individual Investor's Guide to No-Load Mutual Funds" (625 North Michigan Ave., Chicago 60611) and the No-Load Fund Investor" (P.O. Box 283, Hastings-on-Hudson, N.Y. 10706), a monthly newsletter that updates its rankings quarterly.

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