INVESTING IN HIGH RISK-RETURN MUTUAL FUNDS: IS IT WORTH THE RISK?

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1 INVESTING IN HIGH RISK-RETURN MUTUAL FUNDS: IS IT WORTH THE RISK? Dr. Jeffrey Manzi The University of North Texas at Dallas Dr. David Rayome Northern Michigan University ABSTRACT This study examines the investment performance of two high risk-return investments junk bonds and international equities -- to determine how these securities are appropriate for long term investment by individuals. The investor s average five-year holding period returns are evaluated to determine the potential return for the additional risk. INTRODUCTION Most investors are aware of the importance of asset allocation in their investment portfolio. With this in mind, they often buy mutual funds for their personal accounts or for their retirement accounts. In recent years the most popular mutual funds are those which are composed of, or which are compared to, the stocks in the Standard and Poor=s 500 Composite Index (S&P 500). But some investors would like to also include high-yield bonds and emerging market stocks to provide higher returns and further diversification across asset classes. Nevertheless, many individuals refrain from including these securities in their portfolios because they believe that they can only achieve the high returns through an undue level of risk. Markowitz (1952) defined risk as the variance of returns. He showed that an investor s best portfolio is diversified to maximize expected returns while minimizing risk. But, many investors define risk as the probability of not reaching their terminal goals. These individuals plan to invest for the long-term, i.e., more than five years. Financial advisors usually consider a planned five-year holding

2 period as necessary for stock investments. Capital market history shows that stocks have generated high average annual returns over time periods of duration sufficient to allow oscillations of the business cycle to cancel each other. This paper explores the long-term holding period return characteristics of junk bond and emerging market stock investments and examines whether they provide diversification benefits for the individual investor who already has a diversified stock portfolio. This exercise can be used in an investments class to show how seemingly risky investments can actually improve the performance of a portfolio. This study is organized as follows. The first section includes a discussion on related research on junk bonds, emerging market stocks and diversification. Second, the sample and methodology are discussed. Third, the results of the study are presented. Finally, the implications of the study are provided. Junk Bonds Junk bonds sometime behave like other bonds when they move inversely to interest rates. Blume, Keim and Patel (1991) point out that since junk bonds are unsecured and often subordinated, they also behave like equity. Other researchers agree; see, for example, Cornell (1992), Ramaswami (1991), Zivney, Bertin and Torabzadeh (1993), and Kohers and Chieffe (1996). Emerging Markets Barry, Peavy and Rodriguez (1998) examine the performance characteristics of emerging capital markets. They find that although the stocks of firms in emerging market countries are highly volatile, they are beneficial for risk reduction when combined with stocks from developed countries. Although emerging markets have not generated compound returns as high as the returns on the U.S. stock markets, they can provide diversification benefits to investors. Diversified Portfolios Thaler and Williamson (1994) find that most institutions invest 60 percent in equities and the remaining 40 percent in fixed-income securities. Questioning the wisdom of this asset allocation

3 decision, they argue for increasing the investment in equities. Their contention is that although stock returns are more volatile than bond returns, many studies have shown that as the investment horizon increases, the chance of stock returns exceeding bond returns approaches 100 percent. Asness (1996) extends Thaler and Williamson's work. He argues that an investor willing to take high risk by investing fully in stocks can benefit substantially only by investing in a well-diversified equity portfolio. While contending that an individual can invest in high-risk securities and generate high returns in the long-term, he concludes that the problem of how to set up and evaluate a diversified high risk/return portfolio deserves further study. O Neal (1997) examines the benefits from holding more than one mutual fund in the investment portfolio. He finds that time-series diversification benefits are small but that the volatility of terminal wealth can be substantially reduced by investing in more than one mutual fund. In addition, downside risk, which is critical to many investors, declines considerably as more funds are added to a portfolio. Contribution This study examines the asset allocation benefits of adding high-yield bonds and emerging market stocks to the portfolios of individuals with long investment time horizons. These investors are more concerned with the risk of low terminal portfolio values than with the short-term volatility of returns. This example can be used in a college investments class as a dramatic illustration of the benefits of cross-country diversification.

4 DATA AND METHODOLOGY The purpose of this study is to determine whether a core equity portfolio performance can be enhanced by including exposure to risky assets, particularly emerging market equities and high yield bonds. The core equity portfolio is assumed to be an equity portfolio constructed to replicate the performance of the S&P 500 index. Thus, the total returns on the S&P 500 serve as the proxy for the core, or baseline, portfolio. To this portfolio we add exposure to a risky asset, represented by equal weights of high yield (junk) bonds and emerging market stocks. Only total returns to indexes versus managed funds are used in order to remove components of performance that may be attributable to fund management styles and/or of fees. The Bank of America Merrill Lynch US High Yield Master II Total Return Index Value (BAMLHY) was selected to represent a high yield bond investment. This index tracks the performance of U.S. dollar denominated corporate debt that is issued in the US domestic market. Securities in this index are rated below investment grade based on an average of Moody's, S&P, and Fitch. Each security in the index must have an outstanding value of at least $100 million, a remaining term to maturity of more than one year, and a fixed coupon schedule. The Morgan Stanley Capital International Emerging Market Index (MSCIEM) was selected to represent the emerging market equity investment. MSCI considers a market as emerging based on several factors, especially gross domestic product (GDP) per capita. As of 2014, the MSCI Emerging Markets Index covers over 800 securities across 23 markets and represents approximately 11 percent of world market capitalization. In this study the investor makes an equal investment in junk bonds and in emerging market stocks on September 1, The sample period continues until August 31, 2014, a time period of 120 months. Two different holding periods are contrasted to illustrate the benefits of investing in these securities based on the potential terminal wealth rather than on volatility. The investor may choose a one-year holding period or a five-year holding period. An investor who is concerned with the volatility of returns may be tempted to consider only short holding periods with frequent rebalancing. The investor who is concerned

5 with terminal wealth will be more likely to hold investments for longer periods of at least five years. The initial holding periods begins on September 1, 2004 and end on August 31, 2005 for the 12- month holding periods, and August 31, 2009 for the 60-month holding periods. The second holding periods extend from October 1, 2004 to September 31, 2005 or September 31, 2009 for the 12-month and 60-month periods, respectively. The returns are calculated in this manner for the entire 10-year sample period so the final holding periods extends from September 1, 2013 or September January 1, 2009 until August 31, For each portfolio, there are 108 returns in the sample of 12-month holding periods and sixty 60 returns for the sample of 60-month holding periods. The terminal portfolio values equal the returns multiplied by the original portfolio value. RESULTS Table 1 presents the summary statistics for the three types of securities for both holding periods. All the securities have minimum one-year returns which are negative and maximum one-year returns over 40%. The standard deviations and the range of values show that all three can be quite volatile for oneyear holding periods. However, the five-year holding periods have much less volatility. The junk bonds and emerging market stocks have higher annualized returns for the five-year periods than for the one-year periods. TABLE1 Summary Statistics Annualized Returns S&P 500 BAMLHY MSCI-EM 9/1/2004 8/31/ year 5-year 1-year 5-year 1-year 5-year Mean 6.97% 2.82% 9.60% 10.02% 11.97% 5.77% Standard Deviation 18.16% 6.73% 16.00% 3.59% 30.25% 6.24% Median 11.48% -0.18% 7.69% 9.06% 15.08% 7.30% Range 95.01% 23.66% 97.45% 14.59% % 20.25% Minimum % -3.27% % 5.59% % -5.74% Maximum 50.25% 20.40% 66.35% 20.18% 87.45% 14.51% Count For the sample period the average one-year return on the S&P 500 stocks is 6.97% with a standard deviation of but the five-year annualized return is only 2.82% with a standard deviation of

6 6.73. Over the five-year periods, compared to the large stocks of the S&P 500, junk bonds appear to have higher returns and lower risk while emerging market stocks offer greater return but at a higher level of risk. These findings support the expectation that financial markets tend to reward high risk with high returns. Investors who are willing to expose themselves to increased risk may invest in emerging market stocks for the higher returns. However, higher risk may also generate comparatively higher losses. The range for the emerging market series is the highest of the three types of securities. Over the sample time period, an investor in emerging market stocks could have earned as high as % in one year or as low as %. Individual investors who seek higher returns can invest in either junk bonds or emerging market stocks depending on their tolerance for risk. Both securities are risky but the returns on junk bonds have lower variability than those on emerging market stocks. The mean five-year holding period return on the S&P500 is 2.82%, less than that of either of the high risk-return funds. Both measures of risk, the standard deviation of 6.73% percent and the range of 23.66%, are greater than those of junk bonds but less than those of emerging market stocks. For both the 12-month and 60-month holding periods, junk bonds seem to hold the advantage of higher return and lower risk. Characteristics of the Portfolios This study now tests whether an equally weighted investment in the two risky securities yields diversification benefits. Portfolios using one-half of the monthly returns for junk bonds and emerging market stocks are created. One-year and five-year holding period returns for the portfolio are calculated using the same procedure as for the individual securities. TABLE2 Annualized Returns of the Risky Portfolio 50/50 Portfolio: 50% BAMLHY and 50% MSCIEM 1-Year 5-Year Mean 10.78% 7.89% Standard Deviation 21.56% 3.74% Median 12.76% 8.42% Range % 15.23% Minimum % 1.90%

7 Maximum 74.37% 17.13% Count As shown in Table 2, the mean annual return of the one-year portfolio investment is 10.78% and that of the five-year portfolio investment is 7.89 percent. As modern portfolio theory advocates, the average annual return on this portfolio is greater than that on a 100% junk bond investment but lower than the return from a 100% investment in emerging market equities. The standard deviation of the one-year returns on the equally weighted portfolio is and of the five-year returns is As one would expect, the standard deviation in the final portfolio values is lower than the average of the individual investments standard deviations. Individual investors can possibly benefit by diversifying with investment in these securities. TABLE3 Annualized Returns of the Risky Portfolio and S&P 500 Portfolio: 50% S&P 500 and 50% Risky Portfolio 1-Year 5-Year Mean 8.87% 5.36% Standard Deviation 18.59% 4.74% Median 12.88% 4.08% Range % 17.31% Minimum % 0.40% Maximum 60.47% 17.70% Count Table 3 contains the return and risk measures for the risky portfolio combined with the S&P500. Recall that our hypothetical investor already holds a diversified large stock portfolio. The research question in this study is: how will this portfolio be affected by a 50% investment in the risky securities? For the five-year holding periods, the standard deviation is 4.74% versus 6.73% for the S&P500. The range of this portfolio is 17.31% versus 23.66% for the S&P500 alone. The mean return is higher for the portfolio than for S&P500. Many investors may feel that the risk-return trade-off more return for less risk is very attractive. The Sharpe (1966) measure can be used to determine the diversification benefits from adding the

8 high risk-return funds to the index fund portfolio. The Sharpe measure is relevant for the investor choosing a specific fund for a major portion of his/her portfolio. In this study investor is assumed to hold investments in one, two or three asset classes. R i RFR σ i Where: S i is the Sharpe measure for investment i; R i is the return on investment i; RFR is the risk-free rate; σ i is the standard deviation of returns on the investment. As shown in Table 4, with a Sharpe measure of 2.54, 60-month junk bond portfolio had the highest return per unit of risk over the time period of this study. The emerging market equities and the S&P 500 had Sharpe measures of only 0.73 and 0.24% per unit of variability, respectively. TABLE4 Sharpe Measure Holding Periods 09/01/ /31/ Year 5-Year S&P BAML HY MSCI-EM / S&P + 50/ Finally, the combinations of 50% S&P500 and 50% junk bonds and emerging market stocks returned 0.88% per unit of risk. This is generally not considered to indicate significant diversification benefits for individual investors. CONCLUSIONS This study examines the addition of junk bonds and emerging market stocks to a portfolio to address the assumed importance of diversification for higher terminal wealth for individual investors. Long-term holding period returns are calculated because most small investors invest predominantly for long time periods and are largely concerned with the final outcome of their investment. The results reveal

9 that individual investors do not necessarily benefit by diversifying their holdings with more than one fund. This study can be used as an example in an investments class. The students can use recent data from countries they have studied.

10 REFERENCES Asness, C., "Why Not 100% Equities," The Journal of Portfolio Management, Winter 1996, pp Barry, C., Peavy, J.W. III and M. Rodriguez, "Performance Characteristics of Emerging Capital Markets," Financial Analysts Journal, January-February 1998, pp Blume, M. Keim, D.B., and S.A. Patel, Returns and Volatility of Low-Grade Bonds, , The Journal of Finance, 46, no.1, 1991, pp Cornell, B., Liquidity and the Pricing of Low-Grade Bonds, Financial Analysts Journal, Jan./Feb. 1992, pp ,74. Jensen, M.C., The Performance of Mutual Funds in the Period The Journal of Finance, 23, 1968, pp Kohers, T. and Chieffe, N., Business Activity and Junk Bond Default Premiums, American Business Review, 14, no. 2, pp Markowitz, H.M., Portfolio Selection, The Journal of Finance, 7, 1952, pp O'Neal, E.S., "How many Mutual Funds Constitute a Diversified Mutual Fund Portfolio?" Financial Analysts Journal, March/April 1997, pp Ramaswami, M., Hedging the Equity Risk of High-Yield Bonds, Financial Analysts Journal, Sept./Oct. 1991, pp Sharpe, W., Mutual Fund Performance, Journal of Business, 1966, pp Thaler, R. and J. P. Williamson, "College and University Endowment Funds: Why not 100% Equities?" The Journal of Portfolio Management, Fall 1994, pp Treynor, J., How to Rate Management of Investment Funds, Harvard Business Review, 43, Jan./Feb. 1965, pp Zivney, T.L., Bertin, W.J. and K.M. Torabzadeh, A Reexamination of the Investment Performance of Junk Bonds, Quarterly Journal of Business and Economics, 32, no. 2, 1993, pp