Academic journal article Journal of Business and Behavior Sciences

Investing in High Risk-Return Mutual Funds: Is It Worth the Risk?

Academic journal article Journal of Business and Behavior Sciences

Investing in High Risk-Return Mutual Funds: Is It Worth the Risk?

Article excerpt

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

Most investors are aware of the importance of asset allocation in their portfolio. With this in mind, they often buy mutual funds for their personal accounts or for their retirement accounts. For many years the most popular mutual funds are those that are constructed to track the performance of a broad market equity index such as the Standard and Poor's 500 Composite Index (S&P 500). But some investors would like to also include exposure to high-yield bonds and emerging market stocks to provide higher returns and further diversification across asset classes. Nevertheless, many individuals refrain from including these securities in their portfolios because they believe that they can only achieve the high returns through an undesirable exposure to an excessive level of risk.

Markowitz (1952) defined risk as the variance of returns. He showed that an investor's best portfolio is diversified to maximize expected returns while minimizing risk. But, many investors define risk as the probability of not reaching their terminal goals. These individuals plan to invest for the long-term, i.e., more than five years. Financial advisors usually consider a planned five-year holding period as necessary for stock investments. Capital market history shows that stocks have generated high average annual returns over time periods of duration sufficient to allow oscillations of the business cycle to cancel each other.

This paper explores the long-term holding period return characteristics of junk bond and emerging market stock investments and examines whether they provide diversification benefits for the individual investor who already has a diversified stock portfolio. The analytical process followed in this paper can also be used in an investments class to show how seemingly risky investments can actually improve the performance of a portfolio.

This study is organized as follows. The first section includes a discussion on related research on junk bonds, emerging market stocks and diversification. Second, the sample and methodology are discussed. Third, the results of the study are presented. Finally, the implications of the study are provided.

High Yield Bonds

Junk bonds sometime behave like other bonds when they move inversely to interest rates. Blume, Keim and Patel (1991) suggest that since junk bonds are unsecured and often subordinated, they also behave like equity. Fabozzi (2012) supports this by pointing out that high yield bonds represent a dynamic and unique investment opportunity because their performance has attributes of both fixed income securities and equities. Other researchers agree; see, for example, Cornell (1992), Ramaswami (1991), Zivney, Bertin and Torabzadeh (1993), and Kohers and Chieffe (1996). Altman and Nammacher (2002) observe that over the period of this study, high yield bonds have offered a very attractive risk-return tradeoff for individual investors, enabling many prudent investors to realize impressive returns.

Emerging Markets

Barry, Peavy and Rodriguez (1998) examine the performance characteristics of emerging capital markets. They find that although the stocks of firms in emerging market countries are highly volatile, they are beneficial for risk reduction when combined with stocks from developed countries. Although emerging markets have not generated compound returns as high as the returns on the U.S. stock markets, they can provide diversification benefits to investors.

Redman, Gullett and Manakyan (2000) compare the returns of five international mutual funds over three different time periods compared to the Vanguard Index 500 mutual fund and also a portfolio of U.S. stocks. Their results indicate the international mutual funds outperformed the benchmarks for the periods of 1984 - 1994 under the Sharpe and Treynor Indices. The returns of the international mutual funds declined below the U.S. …

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