June 23, 2004 — When buying mutual funds, investors are likely to focus exclusively on returns and ignore potential risks. That strategy can pay off when stocks are humming along, but it may cause pain when the market stumbles.
One way to gauge the risk of a fund is to look at its beta, which measures the sensitivity of returns versus the broader market as represented by a benchmark like the Standard & Poor’s 500-stock index. Bond funds can be benchmarked against the Lehman Brothers Aggregate Bond Index.
A beta of 1.0 means a fund rises and falls at the same rate as the market and is equally as volatile. A higher beta means higher volatility relative to the market, or that a fund moves up and down more than the market. Investments with high betas will do well in a rising market, but they’ll underperform in bear markets, notes Standard & Poor’s mutual fund strategist Roseanne Pane.
While beta gives you an indication of how your fund will react to market movements, “it’s important to at least understand what type of fund you own so that you’re not shocked in a downturn that your fund is doing poorly,” Pane says.
However, funds with higher beta are not necessarily the riskiest. Investors also have to weigh the volatility of the benchmark. The S&P 500, which holds large companies, tends to move less dramatically than the Russell 2000 index of small-caps stocks, for example.
In addition to looking at how volatile a fund is versus the broader market, Advisors and Pane recommend that investors also consider a fund’s standard deviation, which shows how much a fund’s performance has varied over time. A low average annualized standard deviation indicates returns have been less volatile.
Although she doesn’t view it as a measurement of risk, Pane suggests that investors also look at the R-squared statistic, which measures how closely a fund follows the market. Investors should avoid actively managed funds with high R-squared rates, she says, because they’ll be paying higher fees for market performance. Where funds like these are concerned, “you might as well just take an index fund,” she says.