3 Lower-Risk, Higher-Return Stock Funds

One of the first things most of us learn as investors is there is a strong correlation between risk and reward. Investments that carry the most potential for strong gains also typically carry a commensurate amount of risk. At the other end of the spectrum, the safest investments are unlikely to produce returns that make one sit up and take notice. For example, you'd stand a much better chance of seeing strong returns by investing in a biotech company that is developing an important new drug than by keeping the money in cash, though if the drug fails you could very well end up losing money.

Although this risk/return equation serves as a good rule of thumb when assessing the performance potential of various asset types, relative performance within those asset types may vary, with some investments showing a more favorable risk/reward profile than others. To wit, when looking at the performance characteristics of mutual funds, it often pays to look at both their risk and return histories. One way to do this is by looking at a fund's Morningstar Rating, also known as its star rating, which represents its risk-adjusted performance over time relative to its peer group.

But funds that earn 4 or 5 stars--meaning they are funds that have outperformed most of their peers during long time periods--may take investors on a rough ride along the way. And a fund that bucks and bolts like a bull at a rodeo is likely to see more investors head for the exit during market drops than one that keeps volatility more or less in check. In fact, Morningstar research has found that lower-volatility funds tend to produce better investor returns. That is, investors are less prone to buy and sell them at the wrong times.

The Morningstar Risk rating metric measures volatility with an emphasis on downside movements because investors generally are more concerned about losses than they are about their funds experiencing unusually strong gains. Not only is a fund with a Low Morningstar Risk rating easier to own than a more volatile fund, but in rare cases it can bring with it better returns.

Using the Morningstar  Premium Fund Screener tool, we searched for equity funds that had Morningstar Analyst Ratings of Bronze or better and Morningstar Risk ratings of Low--meaning they have exhibited less downside volatility than 90% of their peers. We also layered on a performance screen for funds that have earned 4 or 5 stars--meaning they're among roughly the top one third of performers in their categories. As usual, we eliminated institutional funds and those that are closed to new investors. Load funds are included, but readers who would prefer they be excluded can add that as a screen, as well. You'll find the full list  here, and it includes the following funds.

 Parnassus Core Equity (PRBLX)   
Category: Large Blend | Analyst Rating: Silver    
This fund recently changed its name from Parnassus Equity Income but is still required to keep 75% of assets in dividend-paying stocks. Even so, the emphasis here is more on owning companies that pass the fund's environmental, social, and governance screens and that have wide or increasing economic moats. Its managers run a compact portfolio of about 40 names that was made up of more than 30% small- and mid-cap stocks as of April 30. The fund is prone to sector biases, such as with its current 18% allocation to consumer defensive stocks, which is nearly double the category average. However, its performance record is superb, with a top 1% ranking in the trailing 10- and 15-year periods. For more on this fund, see this Morningstar Minute video.

 Wasatch Core Growth (WGROX)       
Category: Small Growth | Analyst Rating: Silver    
Managers J.B. Taylor and Paul Lambert like to build a relatively compact portfolio of 40-60 stocks with high economic returns, strong management teams, defensible business models, and consistent earnings across economic cycles, says Dan Culloton, Morningstar's associate director of active funds research. They look for smaller companies growing by 15%-20% per year and pay attention to the price they pay, selling when valuations look full; they sold electric-car maker Tesla (TSLA) in mid-2013 after holding it for about a year. But they will also let stocks be if the managers think the firms' long-term earnings potential remains mispriced. During the career of the most senior manager, Taylor, this fund has gained 9.3% annualized from the end of December 2000 through April 14, 2014, well ahead of the small-growth category's 5.8% return and the Russell 2000 Growth Index's 6.8% gain.

 American Funds International Growth and Income (IGAAX)     
Category: Foreign Large Blend | Analyst Rating: Gold    
Income is not the sole focus here, but it influences the strategy, says Morningstar fund analyst Kathryn Spica. The fund strives for an average yield of 3.5% before expenses, which can lead to sector concentrations and the occasional dicey stock. The fund tends to have an overweighting in income-oriented telecoms and utilities (a combined 15% of assets as of March 31), but not to an extreme extent. It employs American's multimanager approach, with each of the fund's three managers independently running a sleeve of the portfolio. There is also an analyst-run sleeve, which usually accounts for 20%-30% of the portfolio. The fund's dividend focus has helped provide a cushion during downturns, boosting this fund's long-term risk-adjusted results. Since its October 2008 inception through December 2013, the fund's 11.3% annualized return well surpassed the 6.8% and 6.6% of its benchmark and typical peer, respectively.

Performance data as of May 19