How Risky Are Your Funds?

After the devastating experience of the 2007-09 bear market, many investors who previously hadn't shown much concern about risk now care about it deeply. Others moved in the opposite direction. As more-speculative fare soared in 2009, they embraced such holdings, striving to take full advantage of what many dubbed a "risk rally."

But what is risk in a mutual fund context? In truth, the concept is not easy to define or recognize. In a Fund Spy column last October, I described how slippery the idea can be. For example, I pointed out that investors who try to avoid all supposedly risky investments are taking on risks of their own.

Today, I'll look at two specific funds to further demonstrate why the concept of risk is so tough to nail down.

A Russian Puzzle
Emerging-markets stocks are typically considered among the riskiest investments around. That's reasonable in a general sense. Emerging-markets funds do tend to have wider swings of performance both up and down. Deep losses are not uncommon.

That said, there are nuances in emerging-markets investments as there are in all others. They can have different levels, and different types, of risk.

Some emerging-markets stocks, for example are large, internationally recognized companies that sell their products globally, while others may operate in just one local or regional market. A fund with substantial stakes in multinationals such as  Petrobras (PBR), Samsung Electronics , and  Infosys (INFY) doesn't face the risk that such firms' fortunes will be badly hurt just because the country in which they are domiciled hits an isolated economic slowdown. The fund also won't have to struggle to exit those positions if the managers decide to dump their shares in these stocks. By contrast, locally focused, less-frequently traded emerging-markets firms would carry both of those risks.

Emerging-markets fund managers often take these issues into account when assessing the potential sources of trouble in their portfolios. Last week, Howard Schwab of  Driehaus Emerging Markets Growth (DREGX) told Morningstar that he considers his fund's Russia weighting (just over 5% of assets in the most recent portfolio) to be overweight from a risk perspective, even though that level nearly matches the weighting in the MSCI Emerging Markets Index. That's because this fund's Russia stake lies mostly in mid-cap names, rather than the giant companies--most notably energy behemoths Lukoil and Gazprom--that make up the bulk of the benchmark's weighting.

In fact, Schwab's comment only scratched the surface of the issue. His point is reasonable, and taking such a view is a prudent way for a manager to look at his portfolio. But for the sake of argument, one could counter that if the fund's entire 5% Russia weighting had been devoted to Lukoil  and Gazprom , it would actually carry more risk than its current Russia stake--which is scattered among several companies in a variety of sectors--because it would be entirely devoted to just two stocks almost entirely dependent on oil and gas.

In response to that, others could add yet another twist. They might agree that carrying just the two holdings would have its risks but, they'd note, the Russian government would never let Lukoil and Gazprom fail. In contrast, failure is a danger for the Driehaus fund's stocks, as it is for most companies. Find a risk on one side, and it's not hard to find one on the other. And that's for just one 20th of the fund's portfolio.

Pharma, Banks, and Malls
A look at  Fairholme Fund's (FAIRX) portfolio adjustments shows the challenges that arise when one attempts to judge an overall portfolio's risk level. In autumn 2009, Fairholme manager Bruce Berkowitz sold most of the fund's stake in  Pfizer (PFE). That stake had reached more than 18% of assets in 2008, and still stood at a hefty 12.8% in August 2009. But then Berkowitz sold more than two thirds of the fund's shares.  He told Morningstar he still liked the company, but that he had become less comfortable with certain aspects of Pfizer's accounting and tax situations, and that he had found better opportunities elsewhere.

One could say the move made the fund safer. You only have to recall Bill Nygren's decision to put more than 15% of  Oakmark Select's (OAKLX) assets into Washington Mutual a few years ago to know that even good managers invite trouble with double-digit allocations to a single stock. In the most recent portfolio, Fairholme Fund's largest individual stake is  Sears Holding , with 8.7% of assets. Pfizer is at less than 3%.

However, Berkowitz didn't just sell those Pfizer shares and head for the golf course. He is a bold, active manager who swoops in whenever he senses exceptional opportunity. Indeed, in the same quarter he took an ax to his Pfizer stake, he bought into  Citigroup (C), General Growth Properties , Rouse, and Winthrop Realty . Citigroup isn't exactly the healthiest company around. General Growth is downright troubled. Rouse (which is owned by General Growth) and Winthrop Realty, are--like General Growth--exposed to the harsh winds of the real estate markets, which have a murky outlook. (More recently, Berkowitz bought into American International Group (AIG).)

Ordinarily, most people would agree that spreading assets among four or five different companies instead of just one would reduce risk. But is that the case with those companies? Hard to say. (The comparison is relevant because the percentage of assets invested in the four companies [excluding AIG] was almost exactly equal to the percentage reduction in Pfizer.) It's even tougher to evaluate the risk situation when you add another piece of information: Not all of the new positions were in common stocks. For General Growth Properties and Rouse, Berkowitz bought fixed-income securities. (And the AIG purchases involved both shares and bonds.) Finally, there's another factor to consider: For all his daring, Berkowitz almost always keeps a substantial amount of assets parked in cash. The fund's most recent portfolio had roughly 20% there.

Clearly, assessing the overall risk level of this portfolio is not a simple task--and cannot be summed up in one word.

Conclusion
Admittedly, a set of Russian stocks and Fairholme's concentrated collection of unpopular companies present particularly juicy illustrations of the complexities of judging risk. But similar dilemmas would arise when looking at most funds. Thinking about risk makes an investor prudent. Just remember, it's not as simple as it sometimes may seem.