Dissecting the risk of individual securities in a mutual fund is a better predictor of risk than traditional measures, which look at entire portfolios, a new study by BARRA found. BARRA looked at 29 domestic equity and bond mutual funds and tested the accuracy of two different risk forecasts.
In both approaches, the firm analyzed the risk of mutual funds over the three-year period ended Dec. 31, 1993, and used the data to project risk in the subsequent year. Both methods looked at monthly data. One looked at the volatility of a entire portfolio's total return; the other aggregated the volatility of the individual securities within the portfolio to arrive at an aggregate risk figure.
The test showed negative returns would seldom have surprised investors if investors had known the fund risks based on the fund holdings. But in many cases, negative returns did surprise them when the portfolio-based risk measure was used. Using holdings-based risk forecasting, just 3% of the realized returns were surprising to investors whereas using portfolio risk, more than 17% of the realized returns were surprising.