Using Risk Measures on Morningstar Fund Reports

Note: This article is part of Morningstar's November 2014 Risk Management Week special report. 

All week long on Morningstar.com, we're looking at the subject of risk and how investors can not only understand it but manage it in their portfolios. When it comes to fund investing, there are several key metrics that indicate how a fund has performed in the past and, therefore, how it might be expected to perform in the future.

Each of these metrics looks at risk in a slightly different way, and it can be difficult to differentiate one from another. So, here is a guide to some of the most useful risk measures you'll find on Morningstar.com fund pages, under the Ratings & Risk tab. None in isolation will tell you everything you need to know. But taken together, they can provide a nuanced picture of how a fund has behaved and help you decide whether a fund's risk profile is a good fit for you.

Bear Market Percentage Rank: Ranks funds within each asset class based on how they have performed over the previous five years in months in which the benchmark S&P 500 Index lost more than 3% (for stock funds) or in which the Barclays U.S. Aggregate Bond Index lost more than 1% (for bond funds).
How to use it: When comparing stock funds with other stock funds or bond funds with other bond funds, those with lower rankings have performed better in down markets than those with higher rankings.
Limitations: Small sample size. Over the past five years, there simply haven't been that many months that meet the metric's criteria of a bear-market environment. Also, the benchmarks used in calculating the metric may not be a great fit with the type of fund.

Downside Capture Ratio: Calculates the extent to which a fund's performance mirrored that of its benchmark during months in which the benchmark lost ground. For domestic-stock funds, the S&P 500 is used as the benchmark; for foreign-stock funds, it's the MSCI EAFE Index; for bond funds, it's the Barclays U.S. Aggregate Bond Index.
How to use it: A ratio of 100 means the fund and benchmark lost an equal amount. If the ratio is higher, it means the fund lost more than the benchmark in those months. And if it's lower, that means it lost less. Lower is generally better because it suggests that during market downturns (as measured by the performance of the benchmark) the fund has lost less than the index.
Limitations: Doesn't tell the whole story of the fund's performance. Often, funds with good downside capture ratios underperform when their benchmark experiences gains. Therefore, it's a good idea to use this metric in concert with upside capture ratio. Also, here, too, the benchmark may not be a great fit for the fund. For more on downside capture ratio, click here.

Morningstar Risk Rating: Measures how a fund compares to its category peers with regard to volatility, with an emphasis on downside volatility.
How to use it: Funds with low or below-average Morningstar Risk Ratings tend to be less volatile than their peers with higher ratings--especially in down markets.
Limitations: Tells you about the fund's volatility relative to its peers but not on an absolute basis. A fund with a low Morningstar Risk Rating in a volatile category may still provide a bumpier ride than a fund with a high rating in a less volatile category.

Sharpe Ratio: Measures a fund's performance relative to the amount of risk it takes. The calculation is based on the fund's standard deviation and its excess return above the risk-free rate.
How to use it: A fund with a Sharpe ratio that is higher than that of a competing fund could be said to be more efficient in terms of delivering performance relative to risk.
Limitations: Doesn't work well when a fund's performance is negative.
For more on the Sharpe ratio, click here. 

Sortino Ratio: Similar to Sharpe ratio, but with an emphasis on downside performance.
How to use it: A fund with a Sortino ratio that is higher than that of a competing fund has delivered better returns relative to its downside volatility.
Limitations: As with Sharpe ratio, it doesn't tell the whole story and is best used in conjunction with other risk metrics.
For more on Sortino ratio, click here. 

Standard Deviation: Reflects the extent to which a fund's performance varies over a given time period.
How to use it: A fund with a high standard deviation is considered more volatile than one with a low standard deviation and, therefore, can be expected to experience more dramatic gains and losses.Unlike, say, the Morningstar Risk Rating, standard deviation allows for a direct volatility comparison across asset classes.
Limitations: Doesn't tell you anything specifically about a fund's volatility to the downside, which tends to be of greater concern to investors than volatility to the upside.For Morningstar's methodology for standard deviation and Sharpe ratio, click here. 

Any discussion of the preceding risk measures would be incomplete without a reminder that all are based on past performance and not necessarily indicative of how the fund will perform in the future. Funds change managers and strategies all the time, just as market conditions change. All of the above metrics are worth considering when analyzing a fund, but the future may not closely resemble the past.

Before buying any investment, it's also worthwhile to make sure you understand the risks associated with the asset classes it invests in, as well as any investment-specific risks. Christine Benz discusses the former set of risks in this article, while Morningstar analysts cover security-specific risks in their analyst reports.