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Solid Funds with Heady Risk Scores

Risk-tolerant investors may need to look beyond the stars.

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We designed the Morningstar Rating for funds in order to suit the average investor. As you probably know, the star rating measures a fund's risk-adjusted performance versus category peers over the trailing three-, five-, and 10-year periods. The return component is fairly straightforward, but the assessment of risk merits some explanation. For the purposes of the star rating, risk is not defined simply as negative returns, as volatility, or as underperforming peers. Rather, the risk calculation examines all variations in a fund's monthly performance, emphasizing downward variations. The star rating thus rewards consistent performance and penalizes erratic behavior. 

Some investors can handle more investment risk than others, though. If you're in that camp, it could be that a fund you find appealing won't get a 4- or 5-star rating. Moreover, while it would be imprudent to use a highly risky fund as a large part of your portfolio, such a fund can work nicely if constitutes a small part of a well-constructed portfolio.

Looking through my own portfolio, for instance, I find  Turner Midcap Growth (TMGFX). This racy number is offered as an option in Morningstar's own 401(k) plan. I keep it limited to a small portion of my account, carefully counterbalanced with value funds and larger stakes in less-volatile large caps. In 2003's massive rally, its 49.5% gain topped all the other funds I own in the 401(k). But its 2-star rating looks pretty woeful. It reflects the fact that the fund's heady risks were fully realized in the 2000-2002 bear market, and the fund's successes before then aren't reflected in the star rating because they were more than five but less than 10 years ago.

Todd Trubey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.