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How Risky Are Your Funds?

The answer is more complicated than you might think.

Gregg Wolper, 04/07/2010

After the devastating experience of the 2007-09 bear market, many investors who previously hadn't shown much concern about risk now care about it deeply. Others moved in the opposite direction. As more-speculative fare soared in 2009, they embraced such holdings, striving to take full advantage of what many dubbed a "risk rally."

But what is risk in a mutual fund context? In truth, the concept is not easy to define or recognize. Here's a look at two specific funds to further demonstrate why the concept of risk is so tough to nail down.

A Russian Puzzle
Emerging-markets stocks are typically considered among the riskiest investments around. That's reasonable in a general sense. Emerging-markets funds do tend to have wider swings of performance both up and down. Deep losses are not uncommon.

That said, there are nuances in emerging-markets investments as there are in all others. They can have different levels, and different types, of risk.

Some emerging-markets stocks, for example are large, internationally recognized companies that sell their products globally, while others may operate in just one local or regional market. A fund with substantial stakes in multinationals such as Petrobras PBR, Samsung Electronics SMSN, and Infosys INFY doesn't face the risk that such firms' fortunes will be badly hurt just because the country in which they are domiciled hits an isolated economic slowdown. The fund also won't have to struggle to exit those positions if the managers decide to dump their shares in these stocks. By contrast, locally focused, less-frequently traded emerging-markets firms would carry both of those risks.

Emerging-markets fund managers often take these issues into account when assessing the potential sources of trouble in their portfolios. Last week, Howard Schwab of Driehaus Emerging Markets Growth DREGX told Morningstar that he considers his fund's Russia weighting (just over 5% of assets in the most recent portfolio) to be overweight from a risk perspective, even though that level nearly matches the weighting in the MSCI Emerging Markets Index. That's because this fund's Russia stake lies mostly in mid-cap names, rather than the giant companies--most notably energy behemoths Lukoil and Gazprom--that make up the bulk of the benchmark's weighting.

In fact, Schwab's comment only scratched the surface of the issue. His point is reasonable, and taking such a view is a prudent way for a manager to look at his portfolio. But for the sake of argument, one could counter that if the fund's entire 5% Russia weighting had been devoted to Lukoil LKOH and Gazprom OGZD, it would actually carry more risk than its current Russia stake--which is scattered among several companies in a variety of sectors--because it would be entirely devoted to just two stocks almost entirely dependent on oil and gas.

In response to that, others could add yet another twist. They might agree that carrying just the two holdings would have its risks but, they'd note, the Russian government would never let Lukoil and Gazprom fail. In contrast, failure is a danger for the Driehaus fund's stocks, as it is for most companies. Find a risk on one side, and it's not hard to find one on the other. And that's for just one 20th of the fund's portfolio.PAGEBREAK

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