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Numbers Don't Tell the Whole Story of Fund Risk

Investing is no science. It's an art. Yet all too often, we make the mistake of assuming that, because so much surrounding our mutual fund is numeric. The buy-and-sell decisions are mathematical.

Nothing could be further from the truth, especially when considering that one of the most difficult-to-understand (and measure) aspects of a mutual fund is its riskiness.

Let's take a quick tour of some of the tools available to assess your mutual fund's risk (or its close cousin, volatility). We'll look at what's the best way to use them to better understand your investments, and perhaps more importantly, why none of these tools alone will give you a truly full picture of your portfolio.

Beta

This common measure compares a mutual fund's volatility with that of a benchmark (usually the S&P 500 index) and is supposed to give some sense of how far you can expect a fund to fall when the market takes a dive, or how high it might climb if the bull is running hard.

A fund with a beta greater than 1 is considered more volatile than the market; less than 1 means less volatile. So say your fund gets a beta of 1.15 -- it has a history of fluctuating 15% more than the S&P 500. If the market is up, the fund should outperform by 15%. If the market heads lower, the fund should fall by 15% more.

But beta, though a useful guide, is far from perfect, especially when used as a proxy for "risk." The problem here, as with many risk measures, is the benchmark. For funds that don't correlate well with the S&P 500, such as international or precious metal funds, beta just doesn't tell you much.

Alpha

Alpha was designed to take beta one step further. It looks at the relationship between a fund's historical beta and its current performance, or the difference between the return that beta would lead you to expect and the return a fund actually gets.

An alpha of 0 simply means that the fund did as well as expected, considering the risks it took. So if that fund with the beta of 1.15 beat the market by 15% (or underperformed it by 15% when the market was down), it would have a 0 alpha. If your fund has a positive alpha, that means it returned more than its beta predicted. A negative alpha means it returned less.

The trouble with alpha is that it's only as good as its beta. If the benchmark S&P 500 isn't appropriate to a fund in deriving its beta, then alpha, too, will be imprecise.

Standard Deviation

Meet the most popular of the risk measures -- one with a distinct advantage over beta. While beta compares a fund's returns with a benchmark, standard deviation measures how far a fund's recent numbers stray from its long-term average. For example, if fund X has a 10% average rate of return and a standard deviation of 5%, most of the time, its return will range from 5% to 15%. A large standard deviation supposedly shows a more risky fund than a smaller one.

But here, again, what's problematic is your reference point. The number alone doesn't tell you much. You have to compare one standard deviation with the others among a fund's peers.

A more glaring problem is that the standard deviation system rewards consistency above all else. A fund is considered stable based on the uniformity of its own monthly returns. So if it loses money but does so very consistently, it can have a very low standard deviation -- down 3% each and every month wins a standard deviation of zero. I don't know about you, but that doesn't signal a risk-free investment to me!

And likewise, a fund that gains 10% one month and 15% the next would be penalized by a high standard deviation -- a reminder that volatility, although perhaps a cousin to risk, itself isn't necessarily a bad thing.

Sharpe Ratio

This formula, worked by Nobel Laureate Bill Sharpe, tries to quantify how a fund performs relative to the risk it takes. Take a fund's returns in excess of a guaranteed investment (a 90-day Treasury bill) and divide by the standard deviation of those returns. The bigger the Sharpe ratio, the better a fund performed considering its riskiness.

Here, again, you have the problem of relativity -- the ratio itself doesn't tell you anything; you have to compare it with the Sharpe of other funds. But this ratio has an advantage over alpha because it uses standard deviation instead of beta as the volatility variable, and therefore you don't have to worry that a fund doesn't relate well to the chosen index.

Morningstar Risk Ratings

The mutual fund rating company provides, in my opinion, one of the best views of risk. Morningstar says that what we investors really care about is when our funds lose money, not when they're doing better than the benchmark or than their long-term averages. It measures how often and by how much a fund trails the monthly T-bill rate, and then compares that average loss with that for the investment class.

The average for a class is 1.00, so numbers above that mean a fund is riskier than its peers, and below is considered less risky.

Here are a few examples. The (VWUSX)Vanguard U.S. Growth fund has a three-year risk rating of 0.94. That means it's viewed by Morningstar as a bit less risky than other domestic equity funds. However, the (OAKSX)Oakmark Small Cap fund is rated 1.42, or 42% more risky than its peers.

As you can see, there's no shortage of tools. It's no wonder that the Securities and Exchange Commission wimped out when it tried to include a standardized risk measure in mutual fund prospectuses. In times such as these, with volatility the only constant in an up-and-down market, we all seek comfort in orderly formulas. But no one number tells with certainty exactly how much risk we take with the funds we buy.

What I suggest is taking a look at these available guides, then also checking out a fund's track record during specific down times -- how did it handle the tough times of the fourth quarter of 1998?

I'll leave you with a conversation I had with one of the best minds in the business: Jack Bogle, senior chairman of Vanguard. "One needs to be conscious of risk, but not push it to the last decimal point," he told me. "It's about awareness, rather than mathematics."

Indeed.

Brenda Buttner's column, Under the Hood, appears Thursdays. At time of publication, Buttner held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While she cannot provide investment advice or recommendations, Buttner appreciates your feedback at TSCBrenda@aol.com.

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