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Fund Spy

Two New Ways of Looking at Fund Risk

These measures provide insights into the past year's wild market.

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One of the most notable effects of the past year's horrendous bear market has been a dramatic reduction in investors' appetite for risk. Risky investments such as emerging-markets stocks and high-yield bonds had a great run before the credit crisis hit, but over the past year badly burned investors have turned away from them in favor of relatively stable, predictable fare such as Treasury bonds and consumer-staples stocks. This effect has been evident in the differing results of various mutual fund categories. The worst-performing categories in 2008 have been Latin American stock and diversified emerging markets, in which the average fund is down more than 55% through December 12. The best-performing categories (apart from bear-market funds, which have had a field day in this market) have been the government-bond categories, led by long government with an average gain of 20%.

It has been more difficult to predict the behavior of diversified domestic-stock funds, which form the core of most people's portfolios, based solely on their category. Average returns for the nine categories in the Morningstar Style Box  range from a 37% loss for small value to a 47% loss for mid-cap growth, but each of these categories includes a variety of funds with different risk levels. In fact, there are various types of risk that funds can exhibit, and some are more relevant to the current market situation than others. Standard deviation and other backward-looking risk measures tell you how volatile a fund has been in the past, but they don't always reflect future risks accurately; some hard-hit areas, such as emerging-markets stocks, exhibited unusually low volatility in the years leading up the current crisis. Portfolio measures such as average valuations and growth rates can give a general but imperfect sense of the risks in a stock fund's most recent portfolio, where high valuations and growth rates tend to correspond to greater risk. (For more on the various types of fund risk, see this article.)

Moats and Uncertainty
All these risk measures can be supplemented with two other portfolio measures that are especially relevant right now: average moat rating and average fair-value uncertainty rating, based on two of the key ratings that Morningstar's stock analysts assign to each stock they cover. A stock's economic moat represents the strength of its competitive advantages, if any. A wide-moat company such as  Coca-Cola (KO) or  Wal-Mart (WMT) has strong advantages that help keep potential competitors at bay; a narrow-moat company has less-compelling advantages; while a company with no moat lacks such advantages, and will likely face a lot of competition if it gets too successful. (You can read more in this definition.) Fair-value uncertainty measures how confident our analysts are in the fair-value estimates they assign to a stock, based on our discounted cash-flow models and analysis of possible scenarios that might occur. Companies with low fair-value uncertainty, most of which are large consumer or health-care stocks, tend to have very stable businesses with predictable cash flows; those rated medium have cash flows that are somewhat less predictable; and so on up to stocks with extreme fair-value uncertainty, many of which face serious problems. (This article provides more information about the rating.)

David Kathman does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.