Morningstar Risk Measures
June 11, 2008 – 6:05 amFor those of you out there who look for actively managed mutual funds, you need to check out Morningstar’s site. Morningstar rates mutual funds and provides a wide variety of valuable data when evaluating mutual funds. They also provide numerous paid for services including research reports, screening services, etc. Although I recommend using no-load, broad-market index funds as the core of a portfolio (or the entire portfolio), this site is still worth reviewing as it contains quite a bit of value information on specific funds.
Today I’d like to briefly discuss a few metrics than can be of value when choosing a mutual fund. More specifically I’d like to discuss “risk” measures.
Standard Deviation
When finance professionals and investment advisors talk about risk with an investment they are usually referring to an investments’ standard deviation. Morningstar reports standard deviation on a 3-year trailing basis, which means that they look at the last three years worth of returns and then calculate how much the price of the security has fluctuated during that time. Standard deviation is a statistical measure, but I won’t bore you (or me) with formulas and statistical proofs. The key thing you need to remember is that one standard deviation means that the fund will be within plus or minus one standard deviation 68% of the time, and 95% of the time it will be plus or minus 2 times the standard deviation. Here’s an example:
Security: Vanguard S&P 500 Index (VFINX)
Mean: 8.47 (this is the average return over the last 3 years)
Standard Deviation: 8.90
This means that the returns of Vanguard’s S&P 500 index fund will fall between:
-.43% and 17.37%, 68% of the time (8.47-8.90 = -0.43%, 8.47+8.90 = 17.37%)
This only accounts for the expected range of returns 68% of the time. If you want to know the statistical range 95% of the time you need to go out 2 standard deviations from the mean, which gives you:
-9.33% to 26.27%
Standard deviation is one measure of risk, but it does NOT tell you several key things, including:
- anything about an investments long term trend. Standard deviations are only calculated over a fixed time frame (depending on the data publisher).
- anything about the best or worst year for an investment. Even at 2 standard deviations it’s still possible for an investment to have gains or losses outside of this range.
- how this investment will add or detract from your existing portfolio. Purchasing an investment with a large standard deviation by itself could be construed as an aggressive investment choice. If the investment has a low correlation (meaning when the value of one is up the others tend to be down, and vice versa) to your other investments, however, this investment becomes much less risky.
- anything about the future. Data published about mutual funds are all based on history, and as the disclaimers always tell you: “past performance is not a guarantee of future results”.
- standard deviation doesn’t tell you anything about the benchmark or standard you are trying to match. If the entire market falls but your investment falls to a lesser degree, then your investment would be viewed as less risky than the benchmark.
Beta
Beta is a measure of an investment’s sensitivity to market movements. By definition a beta of 1.00 means that an investment is expected to move the same amount as the market. As with any statistical measure or comparison, you should be careful to ensure that your security was evaluated against an appropriate benchmark. For example, if a small-company index was used as the benchmark for a fund that invests in commodities, it is unlikely that the beta would be accurate or of any value because the fund and the benchmark have very different characteristics.
The beta for Vanguard’s S&P 500 index fund is 1.00. Beta was calculated using the S&P 500 index, so the resulting answer of 1.00 is not that big of a surprise. In comparison Profunds UltraSector Mobile Telecomm (WCPIX), which I pulled off of Morningstar’s 1-month top performers list, has a beta 3.18.
R-Squared
R-squared is a commonly used statistical measure that indicates how much of a funds’ movements are explained by the movement in the benchmark (comparison) investment. Typically the benchmark investment is the closest market benchmark, like the S&P500 for example. R-squared values range from 0 to 100, with 100 meaning that all price movements are explained by a movement in the index. Therefore, an S&P500 index fund would have an R-squared of 100, because it moves in lock step with the comparison index of the S&P500. An R-squared of 45%, for example, means that only 45% of the investments movements can be explained by the movements of the benchmark index.
What does it all mean? We mentioned before that Beta indicates a funds’ sensitivity to market movements. R-squared helps tell the store of how reliable the Beta figure is. If an investment has a low R-squared, the Beta statistic is less reliable because the selected benchmark isn’t a very good comparison.
Example: R-squared for our S&P500 index fund is 1.00, as it should be since it’s being compared to the standard it tracks. Profunds UltraSector Mobile Telecomm, according to Morningstar, has an R-squared of 47 versus the S&P 500 and 51 versus the “Best-fit” index, which in this case is the Russell Midcap Value index.
Alpha
Alpha measures the difference betweens a funds’ actual performance and it’s expected performance, after adjusting for risk. A positive alpha indicates a fund that has performed better than expected (i.e. better than it’s Beta value would have predicted).
Morningstar calculates Beta, Alpha, and R-squared based on a standard index (S&P500 for equity funds) and also versus a “Best-fit” index. The “Best-fit” index is determined by Morningstar using analytical (regression) methods to determine an appropriate market index.
Bear Market Decile Rank
Morningstar evaluates the performance of a fund during bear markets over the past five years and then places the funds in rank order. A 1 indicates the funds was in the top (best) 10%, and a 10 indicates the fund was in the lowest (worst) 10%.
This metric provides some value for comparison when selecting funds, but it’s not a key decision-maker in my opinion. Also note that this metric does not tell you how much of a loss you might incur during a market downturn. You may still have taken on more risk that you should have even if you invested in a fund with a low bear market decile rank. And, as always, past performance is not necessarily predict future results. 
Sharpe Ratio
The Sharpe Ratio is a risk-adjusted measure based on the research of William Sharpe, a Nobel prize winner. This metric measures excess return adjusted for level of risk. The higher the number, the better the funds’ risk-adjusted return.
So Morningstar has a bunch of data on mutual funds. Who cares? You should. I used to just pick mutual funds based on asset class and historical returns. If the fund was doing well, I was interested. Although I didn’t chase the top funds, I also didn’t evaluate my choices as thoroughly as I should have. Don’t make the same mistakes I did. Try to learn how the professionals make decisions and take advantages of the data available to improve your investing knowledge and skills. Even if you use a professional adviser your knowledge and experience will help you communicate better with him or her, which will ultimately lead to a more valuable professional relationship.
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