Skip to Content
US Videos

How Morningstar Fund Analysts Evaluate Risk

It is important to look at fund's risk from several angles to get a full picture, says Morningstar's Laura Lutton.

How Morningstar Fund Analysts Evaluate Risk

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. How can investors assess how risky their mutual funds are? Joining me to discuss that topic is Laura Lutton. She is director of North American manager research for Morningstar.

Laura, thank you so much for being here.

Laura Lutton: Thanks for having me.

Benz: Laura, this topic of risk management is front and center for us. We're doing a Risk Management Bootcamp on Morningstar.com this week. So I'd like to talk about how investors can determine how risky the mutual funds they might have in their portfolios are, or maybe they are looking to add something and they want to see how risky it might be going forward.

I know that you oversee our analyst group here in Chicago. So let's talk about some of the key things that you like to look at when you are analyzing a mutual fund's risk level.

Lutton: So, the Morningstar Analyst Rating, which is our overall view of the fund, is probably the most comprehensive look at risk because the analysts who are assigning those ratings of Gold, Silver, Bronze, Neutral, and Negative, are really looking at the whole picture and they are helping you determine whether they think that fund is going to manage risk well on a go-forward basis, and the funds that get those medals, those are the ones that we have confidence in their ability to outperform going forward and risk is always a big part of our assessment.

Benz: So, the medalist ratings you're looking for funds--when you award the medalist ratings that will outperform their peers not just on a raw return basis but also on a risk-adjusted basis?

Lutton: Right, and that's because we know from a lot of research that investors don't own riskier funds as well as other funds, right, like what we see in our investor returns, is they buy in once the fund is already been going up and then they sell when things are bad and we don't want that to happen. So, we're very cognizant of risk when we assign those ratings. But the analysts are digging into a lot of different data points to assess risk.

Benz: So, they are looking at portfolio-level risk. They are also looking at things that maybe are a little softer-seeming like what's going on at the managerial level at the fund company?

Lutton: Absolutely. So, one risk would be that the manager doesn't have a big enough team or an experienced enough team to execute that strategy well going forward. So, that would be one of those softer risks that we assess, but we also look extensively at the return stream to make sure that the fund's returns and the risks that they are taking there make sense to us given what the strategy is.

Benz: So all of these risks get discussed in the analyst report and it sounds like you think people should read that if they want to get their arms around it, which I would agree with. But let's talk about some of the data points that attempt to highlight risk. You brought a few that you think are essential really for investors looking to get their arms around their holdings' risk level. The first is, kind of a basic one, standard deviation, a measure of volatility. Let's talk about that one.

Lutton: Yeah, so a lot of times investors think of volatility and risks sort of interchangeably, right, like if the fund is bouncing up and down, its returns are bouncing up and down, is that going to make you nervous or not? So, when analysts in their reports would say, this fund's returns have been more volatile over time, they are typically talking about standard deviation. So, this is just a great way for you to look at that number, compare it to the S&P 500 or a broader index and that will give you sort of a quick-and-dirty way of assessing whether the return stream has been more volatile over time than maybe some of those market standards.

Benz: So, don't just focus on that number in a vacuum because it probably won't mean that much to you, but compare it to a relevant index or maybe the category peer group.

Lutton: Right. Absolutely.

Benz: Another set of data points that you like and I think they are pretty neat too are what we call the upside downside capture ratios. Let's talk about that and I know that's on that same risk page on Morningstar.com for a fund. How can investors use that? They see those red and green arrows. How do they attempt to put those numbers to work?

Lutton: So, again, context here is really important, but what the upside capture ratio is showing for you is how much--when the market is going up how well has the fund done capturing that return. And there's some fund managers out there that they really want to do well when the market is doing well. So, you would expect to see a higher upside capture ratio if that's the manager strategy. Similarly, there are a lot of funds where the strategy is more risk-averse and they want to be really careful that they don't capture a lot of the downside or when the market is doing poorly, they are not locking in those losses, they are avoiding some of them. So, sometimes you will see a fund will have low downside capture but also low upside capture. That's usually a sign that the fund has a lower risk strategy overall.

Benz: And there are some funds that might have the opposite pattern where they have got better upside capture, they do poorly on the downside. Investors don't want to completely disregard them, but if they are looking for a lower risk holding …

Lutton: Right. So, one great example of that would be Wasatch Core Growth, which is a fund that we recently upgraded to Gold. So, it's a small growth fund. That's a riskier part of the market. Small companies are growing quickly and it has high upside capture ratio but it also has a high downside capture ratio. So, its returns are pretty volatile in absolute returns. But when you look at those returns relative to the category, you see that this fund is actually doing a pretty good job of managing its risk within a risky category. So, that again comes back to your point about context. You never want to look at these numbers and think, oh, this is good or bad. You've got to have some yardstick to compare them, too.

Benz: And they are also backward-looking, right, so they might not highlight something going on in the portfolio currently that could be risky in the future.

Lutton: Absolutely. Yes, that's an excellent point. Yeah.

Benz: So, let's talk about some of the forward-looking data points and I know investors sometimes look to things like how concentrated is the fund or is it concentrated in a few sectors. You think another thing that investors should take a look at is the moat rating of the portfolio. So we provide those moat ratings for stocks but we also do it at a whole stock portfolio level. Let's talk about that and how they can be useful.

Lutton: So, if you own a stock fund, where Morningstar covers the equities and even we have a quantitative moat rating as well. So, we assign these ratings to the stocks and the portfolio. The moat rating, it's like a castle, right? I'm sure you've talked with folks about this before. A wide moat is a company with a lot of competitive advantages and defenses around its castle. So, if you see a fund that tends to invest in wide-moat stocks, its return stream is going to be better when the market is down. So, these are kind of defensive companies and the funds that own them tend to be more defensive. So, if you look back at like the financial crisis of 2008, we see a lot of wide-moat funds that did better in that environment than their typical peer. But then in the years since then where the market has been more risk-on they haven't done as well.

So, an equity fund with a wide-moat rating, you could think of it more like an insurance policy, right, like this is the fund that's going to be steadier for you when things are poor. Do you want a whole portfolio of wide-moat equity funds? Probably not because you'd be giving up a lot on the upside when the market is doing really well.

Benz: So, let's talk about how investors, if they are surveying a whole portfolio, how they can they can think about low-risk holdings as well as high-risk holdings? It sounds like based on talking to you that you think investors should have both in their portfolios.

Lutton: Yeah, I think you want to have a mix, right, so that your portfolio is doing well in a number of market environments. And of course, our tendency is to take risk off when the markets are doing poorly and then we're more in favor of risk when the market is up. But the job of your portfolio is really to be all-weather and to do well regardless of whether the market is choppy or smooth, up or down.

Benz: But it does seem like if you are someone who you've been sort of notably skittish in the past and you've completely upended your plans because of market volatility that maybe focusing on some of these lower risk holdings is the way to go?

Lutton: Absolutely. The most important thing is that you can sleep at night. And if that means that your portfolio overall has less risk, that's probably appropriate for you.

Benz: Laura, thank you so much for being here.

Lutton: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Sponsor Center