Top Fund Picks for Risk-Takers

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

All of the best investors take calculated risks: The key to their success is that they make sure they're getting compensated for whatever risks they take on. 

Risk-taking is a must for individual investors, too, as Morningstar.com site editor Jason Stipp asserted in this article. With cash yields as low as they are, investors who want to earn a positive return--never mind one that outruns inflation--have no choice but to edge out on the risk spectrum into bonds and stocks. They might even consider delving into those that qualify as higher risk, such as concentrated equity funds and those that buy beaten-down value stocks, junk bonds, or emerging-markets bonds. Such intrepid investors will have to put up with more short-term price fluctuations than would be the case with more placid funds, and there's the potential they'll even have a loss over their holding period. But higher-risk securities also offer the potential for higher returns than cash and high-quality bonds. For all but the very wealthy, who may be able to make do with returns of 1% or 2%, risk-taking is a must. 

There are a few keys to owning risky assets, however. First, have an appropriately long holding period: For stocks, that means at least a 10-year time horizon, and for high-risk stock funds perhaps even longer than that. Second, plan to balance your risky holdings alongside securities with more modest risk profiles, as doing so is one of the best ways to ensure diversification in your portfolio. (This article highlights some of Morningstar's favorite funds with a history of low volatility; these funds could reasonably be used to counterbalance one or more of the higher-volatility holdings highlighted below.) Finally, make sure you truly understand the strategy of any fund that you own, and that's especially true for higher-risk/higher-volatility holdings. Doing so is the best way to ensure that you hang on through the rough patches that are likely to accompany your holding. 

To help home in on mutual funds that have historically done a good job of compensating their investors for their risks, I used Morningstar's Premium Fund Screener to search for Gold-rated funds with high Morningstar Risk scores relative to their peers. (Adam Zoll explains Morningstar's Risk rating in this article.) The key advantage of the Morningstar Risk metric is that it punishes funds for underperformance during bear markets, whereas standard deviation treats big performance swings, whether to the upside or downside, the same.

The resulting list features funds that have tended to lose more than their peers in previous downturns but that our analysts think will be strong performers in the future. In short, they've been risky but worth it. Premium users can click  here to view or tweak the screen to suit their own preferences--to focus just on no-load funds, for example.

Stock Funds
 Morgan Stanley Institutional Growth (MSEGX) and  Oakmark Select (OAKLX) were the only two domestic-equity funds to make our list. The former is a growth fund whose lead manager, Dennis Lynch, and his team took home Morningstar's Domestic-Stock Fund Manager of the Year honors in 2013, owing to their disciplined strategy and excellent long-term results. Oakmark Select's lead manager, Bill Nygren, has also picked up the Morningstar honor. While Select's concentrated portfolio has experienced short-term volatility and some real missteps (see Washington Mutual, 2008), Nygren's quality- and valuation-conscious approach has been vindicated over longer time frames. 

 Dodge & Cox International Stock (DODFX) was the only foreign-stock fund to make the list. Owing to its large-ish stakes in emerging-markets stocks and management's willingness to delve into unloved names, the fund has also experienced above-average volatility and losses in down markets. But Dodge's seasoned management and disciplined application of a value-oriented strategy, as well as first-rate stewardship at the firm level, make the ups and downs worth it. 

All-in-One/Allocation Funds
For investors who want to take a hands-off approach while also heeding Jack Bogle's admonition not to peek at their investment results along the way, the screen also surfaced some higher-volatility all-in-one funds that earn the highest rating from Morningstar's analyst team. T. Rowe Price's Retirement funds make the cut: Even though their high equity allocations have contributed to higher volatility relative to other target-date fund series, the central thesis that higher equity stakes will improve long-term returns makes sense. Moreover, the funds benefit from T. Rowe's strong underlying funds. 

 Dodge & Cox Balanced (DODBX) also made the list. Its losses were alarming in 2008, as an outsized financials stake spelled trouble, but the fund has rebounded strongly since then. As with Dodge & Cox International, this fund benefits from the firm's patient, value-oriented style as well as their long-tenured management and shareholder-friendly culture.

Finally,  Manning & Napier Pro-Blend Maximum-Term (EXHAX) shows up here, too, even as its conservative sibling appeared our list of low-volatility Gold-rated funds. Not only has the Maximum-Term fund ramped up its equity weighting at profitable junctures, but the team's stock-picking has also been good.

Bond Funds
While investors can reasonably hold the majority--or even all--of their fixed-income portfolios in high-quality, short- and intermediate-term bonds with limited loss potential, they might consider steering a small portion of their fixed-income portfolios to securities with a higher risk/return profile. A handful of bond funds made our list of Gold-rated, high-risk offerings, including two from Loomis Sayles Bond.  Loomis Sayles Bond (LSBRX) is easy to recommend as an "aggressive kicker" bond holding because it gives investors exposure to a number of noncore sectors in a single package; it's managed by a seasoned team, too. Meanwhile,  Loomis Sayles Investment Grade Bond (LIGRX) has more parameters around risk--it typically limits non-investment-grade bonds to less than 10% of assets, for example, But the fund is still quite aggressive by the standards of the intermediate-term bond group. 

For investors seeking a focused play on international bonds,  Templeton Global Bond (TPINX) stands out. In the international bond category, where some managers hew closely to market-cap-weighted fixed-income indexes, manager Michael Hasenstab sets his own path, focusing on bonds from countries with improving fundamentals. The fund's performance profile, not surprisingly, has been markedly different from mainstream peers, but it has also been better.

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