03/18/2010 05:12 am ET Updated May 25, 2011

The Risk of Not Understanding Risk Adjusted Returns

Nothing galls me more that hearing that index funds are fine for those who don't have time to research stocks.

Let's look at the performance of those who do nothing but research stocks -- managers of actively managed mutual funds.

Every educated investor knows that over time index funds outperform the majority of actively managed funds. However, as reported in The Wall Street Journal, a new study by Morningstar takes a look at the risk adjusted returns of the funds that beat the comparable index on an absolute basis.

Morningstar found that over three, five and ten year periods, only 37% of actively managed funds beat their indexes on a risk adjusted basis.

Why is this significant?

Because if a fund took more risk, it is more volatile and the potential for loss is increased.

If you are going to take more risk than the index, the fund should yield greater returns. Investors should be rewarded for the risk they are taking.

How can you tell how much risk your actively managed fund is taking?

Yahoo Finance reports the standard deviation of all funds under "risk." Compare the standard deviation of the actively managed fund to its benchmark index. If it is higher, the actively managed fund is assuming more risk.

Here's an example:

The Fidelity Large Cap Stock Fund (FLCSX) is an actively managed fund. Its three year standard deviation is 25.56%. Its benchmark index is the Russell 1000 or the S&P 500 index.

The Vanguard Large Cap Index Fund (VLACX) is an index fund which benchmarks the S&P 500 index. Its three-year standard deviation is 19.74%.

The Fidelity fund has outperformed its Vanguard counterpart on a absolute basis over the past five years: 2.53% vs. 1.56%. But it took significantly more risk to do so, thereby increasing its potential for both the upside and downside.

Here's the bottom line:

When comparing the returns of comparable funds, it is critically important to be aware of the risks they are taking.

Dan Solin is the author of The Smartest Retirement Book You'll Ever Read.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.