Riskier Funds That Have Been Worth the Ride

When the markets get choppy, the natural reaction is to retreat to safer investments. But the fact remains that to generate strong returns, investors must be willing to tolerate some risk.

To zero in on some funds that have been a good bet despite having high risk scores relative to their peers, we began with the Morningstar Risk rating. This rating is one half of the Morningstar Risk-Adjusted Return measure, best known as the "star rating." The Morningstar Risk rating compares the performance swings of a fund's monthly returns with other funds in the category, and funds are penalized more for their downside swings than for outperforming their peers. (This is because investors tend to be more sensitive to losing money than they are to earning big returns.) In each category, the 10% of funds with the lowest measured risk are dubbed Low Risk, the next 22.5% Below Average, the middle 35% Average, the next 22.5% Above Average, and the top 10% High. We arrive at Morningstar Return in a similar way. In combination, the Risk and Return ratings for the three-, five-, and 10-year periods produce each fund's star rating.

Nearly 600 funds actively followed by Morningstar analysts have earned above-average or high Morningstar Risk ratings. To find funds that appear to be good bets despite their above-average risk ratings, we screened for managers with at least 10 years at the helm and who boast top-third trailing five- and 10-year records. A strong long-term record shows that a fund has made the price of higher risk worthwhile. We also limited the list to funds that are open to new investment and to those with reasonable price tags (an expense ratio less than the category average).

As of Jan. 14, 2008, this screen resulted in a list of 43 funds, each of which had a star rating of 3 or higher as of Dec. 31, 2007. All five mutual fund asset classes are represented: domestic equity, international equity, balanced, taxable fixed income, and municipal bond.

Morningstar.com Premium Members can run this screen themselves by  clicking here. Not a Premium Member? You can still run this screen by taking a free, 14-day Premium Membership trial. (Note that the results may change as funds come in or drop out of the screen over time.)

This screen pulls in a pretty solid group of funds, including a smattering of Analyst Picks as well as managers who are current and past winners of Morningstar's Fund Manager of the Year award. What makes this diverse group of funds similar is that each one has historically seen larger performance swings than the typical fund in each category. To demonstrate,  American Century Vista  ranked at the very top of the mid-cap growth category for 2007 with its impressive 39% gain. However, its earnings momentum focus hasn't fared well every year. During the bear market in 2001 and 2002, the fund posted annualized losses of 28% and 21%, respectively.

 Franklin Federal Intermediate-Term Tax-Free Income (FKITX) is a muni national intermediate fund whose Morningstar Risk rating is also high. This might seem odd given that the fund has posted top-quartile trailing returns for most periods and that it has lost money in only one calendar year (negative 1.9% in 1999). However, the Morningstar Risk Rating is sensitive to all variations in a fund's returns versus its peer group--both on the upside and the downside. It appears that the Franklin Fund's performance swings on the upside versus its peer group have contributed to its high risk rating relative to its peers.

It's also important to keep absolute risk in mind. As we saw with the examples above, it's not surprising that the fixed-income and balanced funds (which have combinations of equity and fixed-income holdings) have lower absolute risk compared with most of the equity funds.

For example,  T. Rowe Price Tax-Free Short-Intermediate (PRFSX) is a muni national short fund, and its worst three-month loss during the past 10 years has been 1.9%. To put that figure in perspective, the worst three-month loss during the same time frame from  BlackRock Global Resources , a natural-resources fund, is 44.4%. This reflects the fund's and its category's propensity for performance swings. In general, the most volatile funds on our list are specialty or emerging-markets funds, whose returns are typically more dramatic than bond or balanced funds.