Three Funds That Went from Relatively Safe to Highly Risky
Lessons about risk from the credit crisis.
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 (FUSFX), 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 (MKHIX), 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.
Arijit Dutta does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.