Three Funds That Went from Relatively Safe to Highly Risky

It's fair to say that the topic of risk has taken center stage again. Markets were exceptionally calm for several years before 2007, which dulled most market participants' perception of risk and led many to invest aggressively. It's been payback time since then. Volatility returned with a vengeance last year after the subprime meltdown and the accompanying credit crisis, and it continues to dog just about all assets. The market's turmoil has sparked a lot of debate and soul-searching about risk-management techniques used by financial institutions and money managers.

All market rallies must one day end, but what's really been shocking in this downturn is the extent of losses in certain investments that were considered downright safe or that supposedly had a tight leash on risk. For example, the ultrashort-bond category, previously regarded as a safe-haven, cash-substitute investment, produced some severe blowups. SSgA Yield Plus (which liquidated in June) and  Fidelity Ultra-Short Bond , for instance, suffered losses on a scale that would've been unthinkable based on their own or the category's past record.  Regions Morgan Keegan Select High Income , a high-yield bond fund, is another prominent example. While that fund is in a risky category that is not foreign to sharp losses, veteran manager Jim Kelsoe had a stellar record in controlling downside. Over the last 12 months, however, the fund has posted a staggering loss of nearly 79%.

We have commented on the toxic mix that drove these funds to despair: security markdowns in their subprime and mortgage-related holdings and forced selling due to shareholder redemptions. It's striking how ineffective the risk-control systems of these money managers and, indeed, those of most financial institutions turned out to be in a liquidity crunch. And fund investors didn't get much help either because most widely used risk measures did not flash red leading up to the bust last year. Let's look at three such measures--standard deviation, kurtosis, and Morningstar Risk--and assess how they did in foretelling these funds' demises. We'll also compare how strongly these measures have factored in the downside risk since markets tumbled.

A Quick Primer
Standard deviation is a statistical measure that captures how variable the return of a security is around its average over a certain time period. The bigger a security's standard deviation the more "risky" it is in the sense that the fund has exhibited larger deviations from the average return. Kurtosis is another statistical measure that captures how deviant a security's returns have been from its average. Unlike standard deviation--which doesn't paint a clear picture of the outliers--bigger, more positive values of kurtosis indicate "fat tails"; that is, the security's returns have shown more extreme outliers. If a security's returns are distributed in a normal bell curve, then extreme outliers are very unlikely, and standard deviation is an acceptable measure of risk. When extreme outliers are more likely to occur, the normal curve is no longer applicable, and kurtosis may be a more suitable proxy for risk.

Morningstar uses a different approach to measuring risk. While the Morningstar Risk measure still seeks to capture uncertainty in investing outcomes, it is more broadly applicable because it does not rely on the normal or any other specific distribution. Instead, it is based on a more direct assessment of an investor's risk tolerance, derived from utility theory. While standard deviation and kurtosis treat upside and downside volatility the same, the key idea in the Morningstar Risk measure is that investors are more concerned with volatility when it's bad, not when they're making money. Utility theory, coupled with the assumption that investors dislike uncertainty (that is, they are risk averse), results in a risk measure that penalizes only downside risk, and relatively heavily so. An asset that accumulates sharp downside deviations from average should quickly rack up large Morningstar Risk penalties, alerting investors to the potential hazards.

Before the Storm
Let's see how someone considering the three funds we mentioned above would have assessed their risks--before the funds went into crisis mode. The following data are as of year-end 2006.

Data as of Year-End 2006
	Std Dev Five Year	Std Dev 10 Year	Kurtosis Five Year	Kurtosis 10 Year	MS Risk Five Year	MS Risk 10 Year
SSgA Yield Plus	0.49	0.64	-0.52	-0.90	0.00	0.00
US OE Ultrashort Bond Category Average	0.67	0.76	1.97	1.04	0.00	0.00
Regions Morgan Keegan Select Hi Inc A	2.55	*	-0.22	*	0.07	*
US OE High Yield Bond Category Average	5.68	6.87	2.40	2.89	0.34	0.50
Fidelity Ultra-Short Bond	0.53	*	-0.41	*	0.00	*
US OE Ultrashort Bond Category Average	0.61	0.76	2.56	1.04	0.00	0.00
*Record not available. Note: Fidelity Ultra-Short Bond did not yet have a five-year record at the end of 2006; three-year data is presented here.

In terms of standard deviation, all three funds look less risky than their peers, the Morgan Keegan fund very significantly so. Also, all three funds have negative kurtosis values, which means extreme deviations from average were very rare, and performance was much more stable compared with their peers (the category average kurtosis values are significantly positive by contrast). Morningstar Risk values tell the same story. The Morgan Keegan fund's low relative Morningstar Risk indicates that it suffered much less downside than the typical rival. The ultrashort-bond category as a whole did not have any Morningstar Risk to speak of, and the two funds cited here were no exception. Even going back 10 years, the SSgA Yield Plus fund shows negligible Morningstar Risk.

Clearly, none of these risk measures predicted the dire outcomes that the funds did face. These portfolios had structured debt instruments tied to subprime mortgages and other assets that trade infrequently and had enjoyed benign market conditions, which effectively masked the funds' downside as far as these risk measures go.

After ...
The following data, which are as of year-end 2007, tell a very different story.

Data as of Year-End 2007
	Std Dev Five Year	Std Dev 10 Year	Kurtosis Five Year	Kurtosis 10 Year	MS Risk Five Year	MS Risk 10 Year
SSgA Yield Plus	3.85	2.85	19.83	40.47	0.16	0.09
US OE Ultrashort Bond Category Average	0.76	0.80	1.30	1.02	0.01	0.00
Regions Morgan Keegan Select Hi Inc A	17.55	*	13.19	*	3.84	*
US OE High Yield Bond Category Average	4.66	6.91	1.41	2.70	0.24	0.50
Fidelity Ultra-Short Bond	2.21	*	12.31	*	0.05	*
US OE Ultrashort Bond Category Average	0.76	0.80	1.30	1.02	0.01	0.00
*Record not available.

All three risk measures show big jumps for each fund. However, it's important to note that the jumps in kurtosis and Morningstar Risk are huge enough to be almost a whole order of magnitude more than the rise in standard deviation. For example, while SSgA Yield Plus is now 5 times more volatile than the category in terms of five-year standard deviation, the fund's corresponding Morningstar Risk value is now 16 times more than the typical peers'. This is because standard deviation weighs positive and negative deviations equally (in fact, kurtosis does, too), whereas Morningstar Risk penalizes only downside variation, and heavily so. Thus, standard deviation, the most frequently used risk measure, is likely to understate the true downside of a portfolio.

Hard Lessons
Overall, this analysis shows that portfolios that contain thinly traded or complex derivative securities have risks that can escape detection for years. If you're relying solely on quantitative measures such as the ones discussed here, the true risks can even escape detection until after it's too late and the damage has been done. Measures that are more sensitive to damaging outliers, such as kurtosis and Morningstar Risk, can do a better job than standard deviation of reflecting the risks of such portfolios. Still, the key drawback for all commonly used measures is that they are backward-looking. The complex derivative securities owned in these portfolios did not have enough history for these measures to rely on, which left investors in the dark about the true downside potential of these funds.

Bottom line: It's important to remember that such measures are backward-looking and can't replace the value in understanding what risks might be harbored that could materialize, but haven't yet. Even so, with financial engineering taking a breather, one hopes that the science of risk measurement will get a chance to catch up.