Understand mutual fund risks

  • All mutual funds contain a measure of risk. The question is how much you’re prepared to accept.
  • The more risk you take, the higher your potential returns should be, and vice-versa.
  • Volatility is a good measure of risk, but it can be misleading at times.

If you’re going to invest money in mutual funds, you have to accept a degree of risk. If you can’t accept that, then keep your money in a savings account — although I have to tell you even that’s not entirely risk-free.

But the mutual fund risk scale is very wide, ranging from minuscule to very high. You can pick any point on it that you like.

Money market and mortgage funds lower risk
If you want to keep risk to an absolute minimum, you can concentrate your mutual fund investments in money market funds and mortgage funds. No money market fund sold in Canada has ever lost money for investors (although it could theoretically happen in certain extreme circumstances). Some mortgage funds may occasionally decline in value, but there are some that have never lost a dime in any calendar year since they were created — in some cases, that covers a span more than two decades.

Another way to minimize risk is to invest in the segregated funds offered by insurance companies. All carry some degree of protection against loss, and in some cases the guarantee covers 100 percent of the amount you invest. However, you’ll usually pay higher fees for these funds and the guarantee only applies if you die or hold for at least 10 years.

Lower risk means lower returns
As a general rule, the reality is that the less risk you take, the lower your potential returns. If you want above-average profits from your funds, then you’ll have to crank up the risk level a few notches. It goes with the territory.

Clearly, the risk/reward relationship must be a key consideration when you decide which mutual funds to buy. If preserving capital and avoiding loss is your prime concern, you’ll select a conservative fund that shares these objectives. In this case, you’ll give up some potential return for a higher measure of safety.

On the other hand, if your objective is to maximize growth and you’re willing to incur greater risk to achieve this, you’ll search out more aggressively managed funds — and there are plenty around.

Certain types of mutual funds are better suited for conservative investors than others. The following table gives a general guideline of the risk/return relationship of various types of funds. Keep in mind, however, that there may be exceptions within any particular group. Review the prospectus of any fund in which you’re interested to be sure its goals are consistent with your own.

Type of Fund Risk Potential Return Potential
Money Market Low Low
Mortgage Low Low
Bond Low/Medium Medium
Balanced Medium Medium
Dividend Medium Medium
Real Estate Medium/High Medium
International equity (Broad-based) Medium Medium/High
U.S. Equity (Broad-based) Medium/High Medium/High
Canadian equity (Broad-based) Medium/High Medium/High
Regional High High
Emerging markets High High
Small cap High High
Sector High High

Next page: Volatility, and other criteria to use

More precise assessments of risk
You can determine a specific fund’s risk potential through the use of a more precise measure known as “volatility” (also called “variability”). Volatility is a mathematical calculation that measures the extent to which the actual monthly returns for a given fund swing up or down from its average return over a given period of time (usually three years).

Many people find the concept difficult to grasp, so look at it this way. Suppose a fund has an average rate of return of 1 percent a month over five years. That average could have been achieved through a series of sharp ups and downs — a gain of 10 percent one month, a loss of 8 percent the next, a jump of 5 percent the next and so on. In that situation, the fund would be said to have a high volatility rating and the risk factor would be significant.

However, if the actual returns throughout the whole period were exactly 1 percent each month — no movement up or down — the fund would have a volatility rating of one (or 0.1 or zero, depending on the scale being used). This implies a very conservative management strategy and a correspondingly low risk rating.

Encorporate common sense as well
The concept of volatility is useful, but it must be combined with a little common sense. For example, most money market funds have volatility ratings of one. That’s because of the low-risk nature of their investments: Treasury bills, term deposits and high-quality short-term corporate notes. An investment portfolio of this type is as close to risk-free as you’ll find and churns out consistent returns month after month. Since volatility scores put a premium on such virtues, money market funds score highly.

If volatility were the only criterion applied, everyone would have all their cash in money market funds. However, there are other things to consider.

The low volatility score achieved by money market funds correctly highlights their safety but disguises the fact that their growth potential is nil and their income potential declines as interest rates fall. They will always perform well relative to risk — because the risk is almost non-existent. But they cannot achieve the growth potential of an equity fund or even a bond fund.

So don’t get so carried away with studying volatility ratings that you lose sight of the underlying characteristics of the fund itself.

Other factors to consider
There are three other criteria to use in determining the risk/reward potential of a given fund.

One is to carefully study the section of the prospectus on management objectives. Words and phrases such as “will seek to maximize growth,” “aggressive management approach,” or “emphasis will be on above-average capital gains” are all tip-offs that you’re dealing with a higher risk fund.

The second is to review the annual performance record of the fund, going back 10 or 15 years. I look especially for losing years; funds which rarely suffer a loss over any 12 month period appeal strongly to me regardless of their volatility rating.

Finally, in the case of equity funds, I look for those that have stood up especially well in difficult conditions, such as in 1990 and 1994. See which funds held up best during those hard times. If they do well under those conditions, it indicates they are conservatively managed and that priority is placed on capital preservation.

That doesn’t mean they will be top performers in bull markets, however — in fact, they probably won’t be because of their cautious approach. You have to decide on your priorities.

Adapted from Making Money in Mutual Funds by Gordon Pape, published by Prentice Hall Canada.