Fund managers shift focus to risk

Recent market volatility is forcing mutual fund managers to pay more attention to how much risk they are taking in their portfolios and to focus more on balance sheets. The change in strategy may improve performance, industry experts said. "A whole generation of managers will be more sensitive" to risk and company balance sheets, said Don Phillips, managing director of Morningstar Inc. of Chicago. For years, many fund managers haven't been measuring risk properly, industry observers said. "We as fund managers ... have embraced a type of risk modeling over the years that measures stock volatility," said Ken Lambden, global head of equities at Schroder Investment Management North America Inc., a New York subsidiary of Schroders PLC of London. It was assumed that the less volatile the stocks in a portfolio were, the less risky the portfolio was, he said. But recent market swings show that that's not always the case.

'AWFUL FRIGHT'

Fund managers who simply relied on volatility as a measure of risk "would have had an awful fright" when markets started to swing, Mr. Lambden said. Preceding recent market gyrations was a long period of low market volatility, a situation that caused many managers to buy stocks that were riskier than they appeared, he said. As a result, many managers likely underperformed their benchmarks by wider margins than they otherwise would have, Mr. Lambden said. Schroder Investment puts more emphasis on risk measures such as active share, which is the percentage of portfolio holdings that differ from the benchmark index, he said. It has helped some Schroder funds to outperform, Mr. Lambden said. The recent performance across all seven of its equity funds, however, has been uneven. Only two of seven Schroder equity funds — the Schroder U.S. Opportunities Fund (SCUVX) and the Schroder U.S. Small and Mid-Cap Opportunities Fund (SMDVX) — were in the top quartile of their fund category year-to-date as of Oct. 28, according to Morningstar. It is unlikely that one single risk measure is the best solution for everyone, said Chris Orndorff, head of equity strategies at Payden & Rygel of Los Angeles. There are numerous ways to measure risk, he said. The important thing for managers is to evaluate their risk measures continually to make sure they are accurate, Mr. Orndorff said. The long-term implications of the recent volatile market "requires people to better understand their risk measure and their risk models," he said. "I think in the past people tended to take it for granted that whatever the output [of the risk model], people generally accepted it." How managers measure risk, however, isn't likely to be the only change that results from the recent market volatility. Managers will also likely pay more attention to balance sheets, Mr. Orndorff said. "A lot of equity investors look at income and cash flow and that's it," he said. If they want to avoid disaster, they will have to delve deeper, Mr. Orndorff said. That is why in 2000, Payden & Rygel combined equity and credit teams. As a result "we see companies more holistically," he said. It hasn't helped Payden & Rygel's equity funds with regard to recent performance. None of its four equity funds — nor three international funds from Metzler-Payden LLC of Los Angeles, a joint venture between B. Metzler seel. Sohn & Co., a banking company in Frankfurt, Germany, and Payden & Rygel — cracked the top quartile of their respective fund categories year-to-date as of Oct. 28, according to Morningstar. Payden & Rygel, however, has the right idea, and given recent market swings it is probably an idea more fund companies will adopt, Mr. Phillips said. "You are going to have a return to analyzing the balance sheets," he added. No longer will a fund manager be able to say simply that a stock is a good buy because it appears cheap on a price-to-earnings basis, Mr. Phillips said. "You have to dig deeper that. You are going to look at the quality of assets." It's a lesson learned by managers who lived through other tough markets, Mr. Phillips said. The volatile markets of 1973 and 1974 convinced many young managers who started during the "go-go" era of the stock market in the 1960s to pay much greater attention to balance sheets, he said. Some would go on to become highly praised mutual fund managers. One is Ralph Wanger, founder of Wanger Asset Management of Chicago, who until 2003 managed the well-regarded Acorn Fund, Mr. Phillips said. That was the year Bank of America Corp. of Charlotte, N.C., acquired the firm, eventually changing its name to Columbia Wanger Asset Management LP, and the fund name to the Columbia Acorn Fund. But recent market volatility may convince young managers to follow in their footsteps, Mr. Phillips said. There's no doubt managers will become more cautious, said Donald Hodges, co-portfolio manager of the Hodges Fund and founder of Hodges Capital Management Inc. in Dallas. In his own practice, he plans on looking a little more carefully at balance sheets. "I think going forward, money managers in general will all be much more sober," he said. E-mail David Hoffman at dhoffman@investmentnews.com.