Academic journal article Journal of Accountancy

Understanding Risk in Mutual Fund Selection

Academic journal article Journal of Accountancy

Understanding Risk in Mutual Fund Selection

Article excerpt

Mutual fund investors still get only half the story. The focus -- in both the financial press and in advertisements -- is on investment return, often precisely quantified by historical returns over several time intervals, with any mention of the fund's relative risk relegated to imprecise generalities. Investors -- and the CPAs who advise them -- need objective criteria concisely communicated to enable them to understand the risks that accompany these returns so they can make rational mutual fund selections. Unfortunately, the financial press often treats mutual fund investors as though they are incapable of understanding basic risk statistics and the fundamental relationship between risk and return that should drive all investment decisions.

The mutual fund universe often is divided into two distinct camps -- winners and losers -- based solely on performance. The same publication that praises a fund manager for outperforming a bull market losses in a downturn, even though this is a logical expectation based on the fund's aggressive investment style and high-risk profile. Furthermore, the aggressive manager may be investing toward a very different benchmark, say, the Russell growth index rather than the Standard & Poors 500. (See the sidebar on page 47.) This type of reporting often comes at an inappropriate point in the investment cycle -- promoting high-risk funds at the peak of a bull market, when it is too late for investors to benefit, and defensive funds after the market already has declined.

Mutual fund lists featuring "funds to consider for the next millennium" or "the 17 greatest funds in the history of the universe" appear frequently in the media and make interesting reading. But, over time, such lists have not proven to be particularly insightful. Funds with records of steady gains and favorable risk-reward, characteristics usually are better choices for long-term investors. This may be apparent following a deep market correction but difficult to fathom during rising markets, a time when many of these same funds are labeled "laggards." Reducing mutual fund selection to simplistic levels presumes an ignorant investing public, which does little to promote successful investing.

This article is designed to help CPAs interpret the various statistical measures of risk as they apply to mutual funds so they will be in a better position to advise their clients on this often complex aspect of stock and bond investing. Knowing how to interpret this information correctly will make it easier for CPAs to make responsible nd informed investment recommendations to their clients.

UNDERSTANDING RISK

Many investors believe the United States is in a period of great uncertainty in its investment markets. This is a conclusion that applies during all market conditions -- except in hindsight. The risk an investor takes is what provides the opportunity for higher returns. Recognizing this makes it clear that more emphasis should be placed on risk analysis when CPAs and their clients make investment decisions. Risk analysis is central to mutual fund research. Focusing on the long-term relationship between risk and return will enable CPAs to establish realistic expectations as to expected performance under various market conditions.

Risk exists when there is uncertainty about whether future returns will differ from the expected returns. Risk is an attribute that without context is neither good nor bad. Accordingly, the CPA's role is not to eliminate risk (few clients would be successful in funding their long-term goals with predictable. Treasury bill returns) but, rather, to control risk and to make sure that clients are adequately compensated for the risks they take. The difference between the required rate of return on a mutual fund -- given its risk -- and the risk-free rate is the risk premium.

There are many sources of uncertainty that determine the appropriate risk premium, including market risk, business risk, liquidity risk, financial risk (leverage), duration and credit risk for bonds and political and currency risk for international assets. …

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