Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
Ahead of the 25th anniversary of the Morningstar Investment Conference, I'm sitting down with Shannon Zimmerman, our associate director of fund analysis. We're going to look at the best ways to think about risk in your portfolio.
Shannon, thanks for joining me.
Shannon Zimmerman: Good to be with you, Jeremy.
Glaser: Let's start with defining risk. With modern portfolio theory, risk sometimes is equated with volatility, but that might not be what a lot of investors are worried about, or what they are thinking about, when they consider risk.
How do you think about risk? Is volatility a good proxy?
Zimmerman: Well, volatility is, I guess, a kind of risk. But I think for the most part, personally as an investor and as an analyst, and when I hear from folks who read our work, the main risk that they are concerned with is the risk of permanent capital loss.
Volatility, I'll speak about that in just a minute. The risk that you're going to put your money to work in a vehicle that you hope will generate positive returns that you can rely on in retirement for big-ticket purchases--the risk that that that might not happen, in fact, you might even lose money--that's the risk that folks want to protect against the most, and rightfully so.
On the other hand, our research shows that investors by and large don't use volatile funds very well. So funds with above-average standard deviation or high beta, you need to have a high risk tolerance, a high tolerance for volatility, to use those funds successfully.
I think I may have mentioned in an earlier segment the fund Fidelity Leveraged Company stock that I cover. Terrific fund, great manager, long-tenured, and terrific long-term total return, about 14% annualized over the last decade. But the typical investor has only gotten about 2% annualized of that return, because it's so volatile.
So risk as volatility does matter, but the main risk that folks want to protect against is the risk of permanent capital loss. One thing that's always struck me as oxymoronic in the parlance of modern portfolio theory is the notion of upside risk. Investors don't really care about upside risk.
Glaser: So if you're worried about losing capital, what are some better measures other than volatility to be focused on then?
Zimmerman: Well, there are two in particular that I would encourage investors to take a look at, and both are available on Morningstar.com. One is this Sortino ratio and the other is Morningstar Risk, which is a part of the overall star rating.
What both of those measures do, although in slightly different ways, is to emphasize downside volatility. So, to the extent that a fund has performed worse than its peers on the downside when the market or its category is in decline, it will receive a lower Morningstar Risk rating, and that gets baked into its overall star rating.
So those are, I think, quite useful measures for getting at downside risk.
Glaser: But if you're looking at these measures, how does that translate into an investment strategy? Volatility has gone up across the board after the financial crisis--it's come back in a little bit since then--but how do you construct a portfolio thinking about these measures?
Zimmerman: That's a great question, because Morningstar Risk, for instance, is a relative rating, it's relative to the other funds in the category. So, if the whole category has gotten more volatile, well, your fund likely has gotten more volatile, too, even if its Morningstar Risk rating is "below average" or "low."
It's a tough question. I think for the most part, what investors want to do is look not just at recent performance certainly, or even five years, or maybe even 10 years. [Instead,] look at the entire manager's track record. If you have a manager that's been on the fund for 15 years or more, how has that manager done over time, particularly as assets have grown or maybe during periods--as we've seen for actively managed equity funds since 2008--during periods of outflows, because if portfolio management was only about stock-picking, that would be an easier job than the one they actually have.
Glaser: You mentioned the volatility in equity funds, but how about in bonds? There's a lot of talk about emerging risks there. What do you expect to hear perhaps at the conference about some of the emerging risks in the fixed-income space?
Zimmerman: Just to judge from reader engagement from the columns and the analyses that we write for [Morningstar.com] and various publications, that's a hot topic. A lot of money has been flowing out of equity funds and into fixed-income funds, and traditionally we think of fixed income (bond) investing as a safer area for investing. But now when you think particularly on the Treasury side, with yields so low, there's only up to go, which means the prices are going to fall. It's a tough thing to think about the bond market as maybe even riskier than the equity market, but some people are making that argument given how low yields have been for so long.
Glaser: So, are investors setting themselves up for a permanent capital loss on the fixed-income side?
Zimmerman: Well, that's a real risk. When Bill Gross was at the conference a couple of years back, he talked about that, and he's the bond kingpin, and he was suggesting that maybe dividend-paying stocks were more attractive for people who were pursuing income.
So, we're going to address that at the conference in a couple of ways. Sarah Bush, who was on one of the earlier videos previewing the conference, will be heading a session called a "Finding Value and Avoiding Landmines in Corporate Bonds," which is a hot topic as people look to put at least a portion of their fixed-income money to work in corporate bonds. So, she'll be leading a discussion with some industry experts on that topic.
My colleague Josh Charlson will be leading a discussion with some industry experts about how to generate income in a multi-asset-class scenario. So you're not just focused on bonds, you're not just focused on dividend-paying stocks, but across the spectrum, how can you diversify your revenue stream of income.
Glaser: How about the risks of going into alternative funds? That's another area that's seeing a lot of investor flows.
Zimmerman: And actually a lot of investor interest, too. At last year's conference, one of the best-attended sessions was on managed futures. I didn't know how popular that would be, but I was really quite struck, and it makes sense because people are looking for not non-correlated investment vehicles in the sense of not being correlated to the overarching market, but low correlation.
In part because of the increasing rise of index investing, correlations are getting tighter and so advisors and their clients are all rightfully asking, what vehicles can I look to that will help me to have parts of my portfolio that go up when other parts go down. Alternatives is one area, and we'll have a couple of sessions on alternatives at the conference.
Then a session that I'm going to be leading will be with the Bill Nygren and Steve Wymer; Nygren of Oakmark, and Wymer of Fidelity. Nygren, of course, is a classic value investor, and Wymer is at the growth end of the spectrum. But both of them have succeeded over the course of many years with portfolios that don't look a lot like their benchmarks. So that's terrific for those managers and their investors, but there are risks that come with that as well. High tracking error means that you can outperform the benchmark, but it also means you can underperform.
Glaser: You've mentioned a lot of these potential market risks, but if you're going to be in the market, you're going to be invested, there's really only so much you can do to potentially mitigate it. What would you say to investors who are really looking to potentially take some risk off the table in a more permanent fashion?
Zimmerman: That's a great question. There is no free lunch in investing; if you're going to be exposed to the markets, you're going to be exposed to the markets--up or down. But there are some things that you control, and one of them is costs--how much do you pay for the funds that you own. Our research shows that a fund's expense ratio is one of the most predictive attributes of that fund in terms of it outperforming if it's below average relative to other funds in its category, or underperforming if it's above average. And in some ways, that's just common sense. A fund's costs, its expense ratio, comes right out of returns that would otherwise flow to investors, and so the higher the expense ratio, the lower the funds returns necessarily are.
So, on that hot topic, we'll have Jack Bogle of Vanguard, and the father of index investing and low-cost index investing in particular, and he'll be having a conversation with Morningstar's Don Phillips. We're very excited about that conversation, and we think it will provide a way for investors to have some tools in the toolbox in terms of controlling risk in a more permanent fashion.
Glaser: Shannon, thanks for your thoughts on risk today.
Zimmerman: Good to be with you.
Glaser: For Morningstar, I'm Jeremy Glaser.