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Funds With the Best Returns Relative to Risk

Stock funds are becoming more volatile, so make sure you understand the risk-reward tradeoff.

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 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.


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If you are worried about the increasing frequency of triple-digit daily fluctuations in the

Dow Jones industrial Average

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, 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.


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While higher "risks" -- as measured by standard deviations -- tended to produce greater rewards, there isn't always a direct correlation between the two. The interim "peaks" in the above chart show points along the standard deviation spectrum indicating outsized returns relative to the decile's standard deviation sequence.

The biggest "peaks" in returns relative to the "risk" sequence can be found in the third and seventh deciles.

The group of funds making up the third decile returned, on average, 1.35 percentage points per year more than the average fund in the first decile, yet the lower bound of the third decile range was close to 2.0 percentage points of total return performance above that of the first decile. In addition, the average three-year annual return for the third decile was higher than that of the "riskier" fourth decile.

Had we known three years ago what we know now, picking a fund in the seventh decile would have been a no-brainer. In late 2004, the logical forecast would have been that the tenth decil should have produced the highest average return of the groupings. Yet it turned out that the somewhat less volatile funds in the seventh decile produced that highest average return of the 10 groups.

If the third and seventh standard deviation deciles continue to be the "sweet spots" in the risk-return spectrum, the funds on the accompanying table should be of interest. They represent funds with Ratings "'buy' recommendations" from the Sept. 2007 third and seventh standard deviation deciles.

All the current standard deviations of the funds in the table are lower than the corresponding data from three years ago, meaning volatility has dropped for each of the funds.

The funds in the less volatile third decile have produced respectable returns in the 18%-24% range for the latest 12 months and in the 12%-19% range annually for three years. But the more volatile seventh decile contains funds that have produced returns in the 26%-47% bracket over the past year and 18%-27% annually for three years.

The choice of the investor is whether to risk more uncertainty -- meaning volatility -- in order to possibly achieve higher returns. That is what investing has always been about, and will continue to be about.

Richard Widows is a financial analyst for Ratings. Prior to joining, Widows was senior product manager for quantitative analytics at Thomson Financial. After receiving an M.B.A. from Santa Clara University in California, his career included development of investment information systems at data firms, including the Lipper division of Reuters. His international experience includes assignments in the U.K. and East Asia.