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Lower Volatility Among Stock Funds: Too Good to Be True?

Russel Kinnel
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Volatility for stocks and, in turn, many stock funds has come down in recent years. Joining me to discuss this phenomenon is director of fund research and Morningstar FundInvestor editor Russ Kinnel.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, in your latest Morningstar FundInvestor cover story, you wrote about trends in standard deviation. You started by looking at the total U.S. equity market as well as foreign equity markets. You noted this downtrend. What do you think is driving that?

Kinnel: The market, as a whole, has become much less volatile. We were in an economic shock in 2008-09. Things were really changing rapidly, but things have kind of moderated since then. We've kind of evolved on this moderate growth trajectory where there's a lot more clarity in the markets. We've had fewer shocks, and that's clear in the volatility in the equity markets. So, things have become much less volatile.

Benz: In your article, you looked at funds where, even though overall equity-market volatility has declined, these particular funds have seen their volatility decline to an even greater extent. Let's take a look at a couple of them because you drilled into why this might be. Let's start with Fidelity Small Cap Stock (FSLCX). You think that that's kind of a fund-specific story there.

Kinnel: That's right. Its volatility has come down a lot. Part of that is market, but part of it is a manager change and strategy tweak. Lionel Harris took over the fund in November 2011. He's got more of a quality bias and a little more of a steady-growth outlook. That means a more stable, staid kind of performance, and we're seeing that in the returns--in the way the fund has performed. And its volatility has come down a lot. So, I think there is something there. He really is a lower-risk manager than his predecessor.

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Benz: Fidelity Leveraged Company Stock (FLVCX), you think that's sort of a different story, where perhaps the backward-looking volatility statistics aren't picking up on what is actually quite an aggressive portfolio.

Kinnel: That's right. In this case, it's more of a head fake, so don't be fooled. Tom Soviero is from Fidelity's high-yield group, and they came up with the idea about 10 or 15 years ago of taking their research on high yield and applying it to stocks. So, the essential idea is to buy really highly leveraged companies that they believe can outgrow that debt or pay it down, and that will really produce good returns on the stock side.

And, of course, it's a high-risk strategy. With the last three years of economic growth and low interest rates, that debt burden has looked much, much less difficult, and so a lot of those stocks have rallied. This fund's volatility has come down a lot--and we've seen volatility in high-yield bonds also come down--but I think that's only a temporary thing. The fund is still clearly high risk. The next time we start to worry about debt, the next time the economy is in trouble, funds like this as well as high-yield debt will be under a lot more pressure.

So, in this case, I would say it's more of a head fake. I still file this fund away in the high-risk category.

Benz: And you would put a high-yield bond fund sort of in the same camp that you alluded to, correct? Even though they seem to be a great investment category--certainly, based on trailing five-year performance--investors should be looking forward in terms of their risk.

Kinnel: For sure. We had a whiff of the risk with the energy sell-off in the fourth quarter of last year and the first quarter of this year, but they've come back. And in general, high yield has had a great run. So, you definitely have to be aware that it's not just like the minor tweak we saw in the fourth quarter; you also have the next recession looming, in which case you could have something as rough as '08. So, be aware that there are some real risks in high yield.

Benz: So, you also discussed funds that are going in the other direction. So, even though we've seen volatility decline for the U.S. equity market in total, some funds have actually bucked that trend. Let's talk about one of them. Fairholme Fund (FAIRX) is a fund that has actually picked up in volatility over that time frame.

Kinnel: That's right, and it's not a manager change or a strategy change. But it is a wide-ranging, focused fund, and Bruce Berkowitz really gives himself the flexibility to buy whatever he thinks is cheap and whatever he thinks can maximize returns. In the last few years, that's a significantly higher-risk kind of company than the kinds he used to own. So, the risk really has come up; 35% of assets are in AIG (AIG). He's got another smaller investment in Sears (SHLD), and obviously those are really high-risk companies. Sears certainly would be the classic cigar-butt kind of play. You're just hoping to make a little money out of it.

But at the same time, he has also significantly cut cash. Part of that was because he got swamped by redemptions a few years ago, but he has also kept cash low even as he could have sold more. So, historically, he had a more stable stock portfolio and a big cash stake, which moderates risk. Now, he's got higher-risk stocks and a smaller cash stake, and so the fund really is a pretty high-risk fund. Clearly, for most people, it's a fund that should really only be a modest part of your portfolio. It's not really a core holding in my view.

Benz: Let's discuss the broader takeaways. Of course, you drilled into a lot of other fund specifics in your article, but in terms of investors thinking about volatility and thinking about managing risk on a forward-looking basis, is it your view that maybe some investors have gotten a little complacent about risk? How could they do a better job of sniffing it out on a forward-looking basis so that they know what risks are embedded in their fund portfolios?

Kinnel: I think, seven years into a bull market, it's just natural that we've probably now forgotten a little bit about risk, so I think one simple thing [an investor can do is] just make sure you're really diversified. Recognize that every recession and every bear market is different. The last bear market hit financials the heaviest; the previous one hit tech. So, value managers last time and growth managers the time before. We have no idea where the next one will be. We don't know which countries will be hit hardest. We don't know how bonds will do. So, be diversified, make sure that you don't have too much in one fund or in one sector. I think that really makes sense. But also review your funds' risk levels: What about their strategies make them low risk, and how do they all interact together?

Benz: And you also think that perhaps there's a case for investors holding at least a little bit more cash than usual in the current market environment.

Kinnel: That's right. In my own portfolio, I'm letting cash build slightly. I don't think you want to make a crazy bet. Markets are too hard to predict. But it's not a bad idea to let cash build a little. And we heard this theme at the conference last week--that people are building up a little cash with that--and I think that makes sense for individual investors. Build cash a little. And if some buying opportunities come, then the sell-off will be painful on the one hand; but on the other hand, you'll be able to take advantage by buying, and that'll get you back to even quicker.

Benz: Russ, thank you so much for being here to share your insights.

Kinnel: You're welcome.

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

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