This article is an extract from a conversation held between Morningstar’s Jeremy Glaser, markets editor, and Shannon Zimmerman, associate director of fund analysis. Zimmerman talks about risk.
In modern portfolio theory, risk sometimes is equated with volatility. Is volatility a good proxy?
Volatility is a kind of risk. But I think for the most part, personally as an investor and as an analyst, the main risk people are concerned with is the risk of permanent capital loss.
The risk that you're going to put your money to work in a vehicle that you hope will generate positive returns and that you can rely on in retirement for big-ticket purchases. Now the risk that that that might not happen, in fact, you might even lose money--that's the risk that folks want to protect against the most, and rightfully so.
On the other hand, our research shows that investors don't use volatile funds very well. To use funds with above-average standard deviation or high beta successfully, you need to have a high risk tolerance, a high tolerance for volatility.
One of the funds that I cover is a terrific fund-- great manager, long-tenured, and a return of about 14% annualized over the last decade. But the typical investor has only gotten about 2% annualized of that return, because it's so volatile.
So risk as volatility does matter, but the main risk that folks want to protect against is the risk of permanent capital loss.
If you're worried about losing capital, what are some better measures other than volatility to be focused on?
There are two in particular that I would encourage investors to take a look at, and both are available on Morningstar.com. One is this Sortino ratio and the other is Morningstar Risk, which is a part of the overall star rating.
What both of those measures do, although in slightly different ways, is to emphasize downside volatility. So, to the extent that a fund has performed worse than its peers on the downside when the market or its category is in decline, it will receive a lower Morningstar Risk rating, and that gets baked into its overall star rating.
How does that translate into an investment strategy? How do you construct a portfolio thinking about these measures?
Morningstar Risk is a relative rating, relative to other funds in the category. So, if the whole category has gotten more volatile, well, your fund likely has gotten more volatile, too, even if its Morningstar Risk rating is "below average" or "low."
I think for the most part, what investors want to do is look not just at recent performance certainly, or even a few years. Instead, look at the entire manager's track record. If you have a manager that's been on the fund for 15 years or more, how has that manager done over time, particularly as assets have grown or maybe during periods of outflows, because if portfolio management was only about stock-picking, that would be an easier job than the one they actually have.
But if you're going to be in the market, you're going to be invested, there's really only so much you can do to potentially mitigate it. What would you say to investors who are really looking to potentially take some risk off the table in a more permanent fashion?
There is no free lunch in investing; if you're going to be exposed to the markets, you're going to be exposed to the markets--up or down. But there are some things that you control, and one of them is costs--how much do you pay for the funds that you own.
Our research shows that a fund's expense ratio is one of the most predictive attributes of that fund in terms of it outperforming if it's below average relative to other funds in its category, or underperforming if it's above average. And in some ways, that's just common sense. A fund's costs, its expense ratio, comes right out of returns that would otherwise flow to investors, and so the higher the expense ratio, the lower the funds returns necessarily are.
