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Funds With the Best Returns Relative to Risk

The rise in volatility in recent months is prompting concerns about the health of the stock market. It's certainly something you should take into consideration in selecting a mutual fund.

But while the amplitude of stock price movements has been on the upswing, it's arguably a return to historical norms from what has been an abnormally low level of market volatility.

A study of 1,468 open-end mutual funds in TheStreet.com Ratings' database indicates that, even with the recent uptrend in volatility, the medium-term variability of returns remains significantly below the level of three years ago. Only diversified U.S. stock funds were included in the study. Funds that focus on stocks in a specific market sector and funds that track a stock index were excluded.

The measure of volatility used in the study was the annualized standard deviation of total returns for the trailing 36 months. This is basically defined as the annualized value of the up and down bounds within which approximately 68% of the month-to-month fluctuations in a fund's monthly returns deviate from its annualized rate-of-return trend.

Thus, a low standard deviation means that a fund's returns have been relatively steady during the measurement period. Because many investment analysts equate large up and down fluctuations with uncertainty, standard deviation is often used as a measure of investment risk.

The average annualized three-year standard deviation for the group was 10.28% for the 36 months ended Sept. 30, 2007. That's significantly lower than the corresponding value of 17.38% for the three years ended Sept. 30, 2004.

Moreover, despite the recent bulge in volatility, the current standard deviation values are lower than three years ago across all subsectors of the group of funds in the study. The 2007 and the 2004 standard deviation values each were divided in 10 groups, or deciles. Every decile's average standard deviation for 2007 was markedly lower than the corresponding 2004 grouping, as can be graphically seen in the bar chart below.

In fact, the six deciles with the highest volatility this year each averaged a lower standard deviation than the very lowest decile three years ago.


VOLATILITY COMPARISON: 9/2004 VS. 9/2007
Click here for larger image.

If you are worried about the increasing frequency of triple-digit daily fluctuations in the Dow Jones industrial Average, you should take funds' standard deviations into account when evaluating portfolio additions. The chart below shows how funds with different ranges of standard deviation in September 2004 performed over the subsequent three years. The ranges indicated by each line represent the three-year annual returns achieved by 68% of the funds in that decile grouping. The vertical dash in each line represents the average annual return for the group.

The average standard three-year deviation for each decile group appears at the bottom of the chart.


3-YEAR VOLATILITY (AS OF SEPT. 2004) & SUBSEQUENT
3-YEAR PERFORMANCE
Click here for larger image.

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