The analysis of risk-adjusted mutual fund performance is based on a concept of downside risk that has been under investigation at the Pension Research Institute since 1980. Since then, the number of investors using some form of downside risk has grown dramatically.
The Pension Research Institute analysis starts with the equity funds Pensions & Investments ranks as the 100 most popular among defined contribution funds. Morningstar Ondisk, from Morningstar Inc., Chicago, is used to calculate the raw five-year returns; funds with less than five years of data are excluded.
The downside risk measure used here is similar to standard deviation, except PRI considers only the deviations below some minimal acceptable return as risky. Just as past returns do not predict future returns, the risk a manager took in the past does not predict the risk to be taken in the future. Nevertheless, it is useful to know both risk and return when measuring the performance of managers.
What is the difference between PRI's measure of downside risk and the more traditional risk measures of variance and beta? Downside risk captures the risk of not achieving your goals; variance captures the risk of not achieving the average return; beta captures the risk of being in the market. These are three different risk measures, capturing three different kinds of risk. All risk measures are useful sometimes and misleading at others. Therefore, the more ways you have of looking at risk, the better.
Because the traditional risk measures are readily available, this limited analysis adds another dimension to understanding the risks associated with these investments.
The accompanying graph showing the risk-return profiles of the Frank Russell indexes can be used as a point of reference. G stands for growth; V stands for value; the 1000 series represent large-capitalization stocks: the 2000 series represent small-cap stocks; the 3000 is a broad based index; and midCap is for midsized stocks. Thus, on the graph, 1000G is an index of growth stocks from the 1,000 largest companies.
The quartile rankings are based on the funds' five-year risk-adjusted return for what PRI has identified as the average risk-averse investor. The profile of the average investor is based on the following assumptions:
Earning the Treasury-bill rate of return will not be enough to enable the average investor to accomplish retirement goals. This eliminates T-bills and money market funds for determining the minimum acceptable return.
Everyone ought to be diversified across asset types. It is not a question of whether to invest in stocks or bonds; it is a question of how much to put in each. We assume the benchmark mix for the average risk-averse investor is 50% equity and 50% fixed income.
Earning the average historical return on stocks and bonds will be sufficient to accomplish the average investor's goal. Given a 50/50 mix, the minimum acceptable return is 8.7%. Therefore, any returns above 8.7% do not contribute to risk, and the further returns fall below 8.7%, the greater the risk of not accomplishing your goal.
Those funds in the first quartile are the top performers. To estimate where your fund placed on the graph, find the five-year return and the risk number for your fund, then locate where they meet on the graph. If your fund's return fell above the red line on the graph, he or she not only achieved a return that will accomplish your goal, but did so while beating a broad-based passive index, the Russell 3000.
The above table lists the relevant statistics for all FRC indexes. The sector of the market that performed best over this period was small-cap value stocks (FRC 2000V), which had a risk-adjusted return of 9.7%. In other words, 210 basis points was subtracted from the average return of 11.8% to take into consideration the risk of not being able to retire, if one invested in this index. The worst performance was T-bills, with a risk-adjusted return of 4.6%.
This brings up an important point: while funds that owned short-term fixed-income instruments like T-bills had the best returns for the past year, they were a poor investment for a longer holding period, like five years. Investing for retirement requires a long-term investment strategy. Don't focus your attention on performance for the past quarter, or past year. If your manager's returns are above the red line, you're on track, and that's what is most important.
The next question of importance is: did my manager perform better than a passive index for the investment style I selected. If your small-cap manager is below the red line, but has a higher return than the FRC 2000G index, the performance was good for that sector of the market. Keep in mind that buying the favored sector of the past may result in never owning the sector that will be favored in the future. It is diversification that reduces risk, not style selection.
We at PRI sincerely hope this report will provide useful insights about the return and risk characteristics of the most popular funds for defined contribution plans, and we look forward to your comments.