High risk funds cause investors to buy high, sell low. By Steven Goldberg, Contributing Columnist June 30, 2006 High-risk funds don't serve investors well. That's the message sent by Don Phillips, managing director of Morningstar, Inc. at the firm's annual fund conference in Chicago. By themselves, the words may sound like pablum, but Phillips and his colleagues have done the work to back up his words.Here's what they did: They divided each category of mutual funds -- from emerging markets to municipal bonds, from large-company growth to small-company value -- into two halves. The first half included those funds that exhibited the most volatility -- that is, their returns bounced around more from month to month. The second half encompassed the less-volatile funds. Then they combined all the high-risk funds together and all the low-risk funds together and looked at returns over the past ten years. Lower risk funds did slightly better, returning an annualized 8.7% versus 8.3% for higher-risk funds. That's a small difference. But the real difference shows up in how investors' did. Investors, on average, earned an annualized 8.5% in the lower-risk funds but just 5.1% in the higher-risk funds. That's a large gap. You might wonder how Morningstar calculates what investors actually earned, which is something fund geeks call dollar-weighted returns. Simply put, dollar-weighted results measure the returns of each dollar invested. An example helps. Take a fund with $3 million in assets. It has a great year, gaining 100%. Money pours in. The next year, with $1 billion, it loses 50%. The fund's two-year, cumulative return is zero. But the overwhelming majority of the fund's investors lost money because they missed out on the great year and were in the fund only while it was losing money. Says Phillips: "High-volatility funds tempt you to buy high and sell low." Advertisement Morningstar also compared the dollar-weighted returns at some of the nation's biggest fund firms against the reported returns of their funds. The results here are striking: The results of those families that mostly market lower-risk funds are only slightly better than families that sell riskier funds. But the dollar-weighted returns of low-risk shops blow away those of the higher-volatility companies. Because the returns include equally weighted assets from all the firms, measuring the raw performance isn't all that meaningful. After all, most bond funds do worse than stock funds. So Phillips created what he calls a "success ratio": the percentage of total returns that investors actually realized in their dollar-weighted returns. Consider the American funds, the nation's largest fund purveyor and a company known for keeping risk low. The dollar-weighted returns for the ten-year period ending last December 31 was 10.1% annualized. That compared with fund annualized returns of 10.6%. Dividing 10.1 by 10.6 gives American a sparkling success ratio of 95%. Dodge Cox did even better, delivering annualized 12.5% dollar-weighted returns compared with reported fund returns of 12.8% annualized. Do the math and you get a success ratio at Dodge Cox of 98%. Other firms with high success ratios: Franklin Templeton, 94%; Fidelity, 91%; and Vanguard, 86%. On the high-risk side of the equation, look at Janus, a go-go shop that epitomized the excesses of the late 1990s. Its funds ten-year total returns were 9.1% -- less than the American funds or Dodge Cox, but not horrible. However, their dollar-weighted returns over the ten years were just 2.3% annualized. The success ratio was just 25%. Finally, Phillips looked at where investors are putting their money. The upshot: Over the past two years, investors have been taking money out of companies with low-success funds and putting it into firms whose funds sport higher success ratios.