Morningstar Advisor - February/March 2009 - (Page 35) Exhibit 1: Tranquil Times Year-End 2006 Std Dev 5 Yr Std Dev 10 Yr Kurtosis 5 Yr Kurtosis 10 Yr MS Risk 5 Yr MS Risk 10 Yr SSga Yield Plus Ultrashort-Bond Category Avg Year-End 2006 0.49 0.67 0.64 0.76 Std Dev 3 Yr –0.52 1.97 –0.90 1.04 Kurtosis 3 Yr 0.00 0.00 0.00 0.00 MS Risk 3 Yr Keegan fund significantly so. Also, all three funds had negative kurtosis values; this means that extreme deviations from average were very rare, and performance was much more stable compared with their peers. (The category average kurtosis values were significantly positive by contrast.) Morningstar Risk values told the same story. The Morgan Keegan fund’s low relative Morningstar Risk indicated that it had suffered much less downside than the typical rival. The ultrashort-bond category as a whole did not have any Morningstar Risk, and the two funds cited here were no exceptions. Even going back 10 years, the SSgA Yield Plus fund showed zero Morningstar Risk. Clearly, none of these risk measures predicted the dire outcomes that the funds faced. These portfolios had structured debt instruments tied to subprime mortgages and other assets that trade infrequently and had enjoyed benign market conditions, which effectively masked the funds’ downside as far as these risk measures go. At year-end 2006, nothing appeared abnormal over at the Dodge & Cox funds either. Both funds had risk measures one would expect of these offerings; they generally hovered around their category averages. The Storm Hits Fidelity Ultra-Short Bond Ultrashort-Bond Category Avg Year-End 2006 0.53 0.61 Std Dev 5 Yr –0.41 2.56 Kurtosis 5 Yr 0.00 0.00 MS Risk 5 Yr Regions Morgan Keegan Select High Income High-Yield Bond Category Avg Year-End 2006 Std Dev 5 Yr 2.55 5.68 Std Dev 10 Yr Kurtosis 5 Yr –0.22 2.40 Kurtosis 10 Yr MS Risk 5 Yr 0.07 0.34 MS Risk 10 Yr Dodge & Cox Stock Large-Value Category Avg Year-End 2006 11.86 12.09 Std Dev 5 Yr 14.13 13.57 Std Dev 10 Yr 1.57 2.07 Kurtosis 5 Yr 1.42 1.38 Kurtosis 10 Yr 1.54 1.56 MS Risk 5 Yr 2.20 1.95 MS Risk 10 Yr Dodge & Cox Balanced Mod Allocation Category Avg 7.76 7.66 9.13 9.24 1.41 0.85 1.06 0.77 0.64 0.60 0.89 0.89 Note: Fidelity Ultra-Short Bond did not have a five-year record at the end of 2006. Regions Morgan Keegan Select High Income did not have a 10-year record. means that these outliers exist in the security’s returns; in other words, the returns distribution has “fat tails.” If the security’s returns can be distributed in a normal bell curve and extreme outliers are unlikely to occur, standard deviation is an acceptable measure of risk. When extreme outliers are more likely to occur and the normal curve is no longer applicable, kurtosis may be a more suitable proxy for risk. Morningstar uses a different approach to measuring risk. Morningstar Risk is still intended to capture uncertainty in investing outcomes, but it is more broadly applicable because it does not rely on a normal or any other specific distribution. Instead, it is based on a more direct assessment of an investor’s risk tolerance, derived from utility theory. While standard deviation and kurtosis treat upside and downside volatility the same, the key idea in Morningstar Risk is that investors are more concerned with volatility when it’s bad, not when they’re making money. Utility theory, coupled with the assumption that investors dislike uncertainty (they are risk-averse), results in a risk measure that penalizes only downside risk, and relatively heavily so. An asset that accumulates sharp downside deviations from average should quickly rack up large Morningstar Risk penalties, alerting investors to the potential hazards. Before the Storm One year later, as the credit crisis was beginning to unfold, the risk data of the bond funds, shown in Exhibit 2, tells a different story. All three risk measures show big jumps for each fund. It’s important to note that the jumps in kurtosis and Morningstar Risk are huge enough to be almost a whole order of magnitude more than the rise in standard deviation. For example, while SSgA Yield Plus is now five times more volatile than the category in terms of five-year standard deviation, the fund’s corresponding Morningstar Risk value is 16 times more than the typical peers’. This is because standard deviation An investor assessing the risks of SSgA Yield Plus, Fidelity Ultra-Short Bond, and Regions Morgan Keegan Select High Income at year-end 2006, before the funds went into crisis mode, would have seen the risk scores in Exhibit 1. In terms of standard deviation, all three funds looked less risky than their peers, the Morgan MorningstarAdvisor.com 35 http://www.MorningstarAdvisor.com
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