Six key forward-looking risk factors for fund investors

High-yield bonds are a good recent example. Amid a generally improving economy, high-yield, or junk-bond, funds cranked out a steady stream of positive returns from 2003 through 2007. Their worst average loss in any single quarter during that stretch was 1.6%, so statistics that focus on downward variations in returns, such as Morningstar Risk, would have looked pretty benign at that time. If you were shopping for a bond fund in early 2008, high-yield bonds might have looked like a relatively low-risk way to pick up a higher yield than you'd earn with a higher-quality bond fund. Yet in mid-2008, funds in the High Yield Fixed Income category began dropping and continued to plummet. All told they fell a stunning 21.3%, on average, for the year.

So how could you have sniffed out the volatility in high yield ahead of time, when backward-looking statistics made these investments look benign? To do that, you'd have to spend some time assessing the investment's risks on a forward-looking basis.

For funds, there are two key types of forward-looking risk: investment-related risk, such as holding a lot of assets in a single stock or junky bonds, and operational risk -- for example, the chance that a recent change in ownership structure will cause managers to leave. Both types of risk are well worth considering.

Investment-style risk

Morningstar style boxes and categories, sectors and concentration are key factors to focus on when judging the kinds of risks a fund is taking on and whether it's right for you.

Style Box positioning --The Morningstar Style Box is a great way to find out how risky a fund is apt to be. Over the long term, large-cap value stock funds, which land in the upper-left corner of the Morningstar Style Box, tend to be the least volatile -- they have fewer performance swings than other stock mutual funds. On the opposite end of the spectrum, funds that fall in the small-cap growth square are typically the most volatile group.

A fund such as   Dynamic Power Small Cap  , which owns small, growth-leaning stocks, is likely to experience more dramatic ups and downs than one holding large, budget-priced stocks, such as   Templeton Canadian Stock  . Dynamic Power Small Cap might deliver higher returns over the long haul, but its performance will tend to be much more erratic. Investors may have to go on a pretty wild ride to get those returns, and there will be more occasions when their accounts will be at a low ebb than will be the case with the Templeton fund.

Similarly, our bond style box shows how risky one's fixed-income fund is apt to be. Generally speaking, the safest square of the bond style box is the top-left square -- home to funds with limited interest-rate sensitivity and high credit qualities. Such funds won't see their bonds drop in value too much if interest rates go up, and they focus on government and high-quality corporate bonds, meaning that there's little risk that the issuers will fail to keep up with their bonds' interest payments. Funds that fall into this square of the style box are often just a notch riskier than money market funds. Meanwhile, the riskiest square is the bottom-right-hand corner of the box. Happily, few funds occupy it--bond funds tend to take on credit or interest-rate risk, usually not both.

Sector positioning --In addition to considering a fund's investment style, it also helps to eyeball its sector positioning to gauge how vulnerable it is to a downturn in a certain part of the market. A fund that bets a lot on a single sector -- particularly if it's a sector that houses a lot of high-priced stocks such as technology -- is likely to display high volatility, with dramatic ups and downs. As long as the manager's strategy doesn't change, that volatility will continue. Sometimes the fund will make money and sometimes it will be down, but its volatility will remain high, reminding investors that even though the fund may currently be making a lot of money, it also has the potential to fall dramatically.

Although there are no rules of thumb for how much is too much in a given sector, one starting point is to compare your fund's sector weightings with those of other funds that practice a similar style as well as with a broad-market index fund such as   BMO Equity Index   or   TD NASDAQ Index  . This is not to suggest that you should automatically avoid a fund with a big wager on an individual sector; in fact, some of the most successful investors are biased toward a market sector or two. (Exhibit A: Warren Buffett, whose Berkshire Hathaway   BRK.B is heavily skewed toward financials stocks, particularly insurers.) But you'll need to balance that fund with holdings that emphasize other parts of the market.

Concentration --Just as a fund that clusters all its holdings in a sector or two is bound to be more volatile than a broadly diversified portfolio, funds that hold relatively few securities are riskier than those that commit a tiny percentage of assets to each stock. The reason is simple: If one of the picks in a concentrated fund were to go bankrupt or run into some other type of trouble, it would take a far bigger bite out of returns than if a more diversified fund got caught with the same bum stock. (For similar reasons, concentration should also be a consideration when evaluating bond funds, particularly those that focus on junk bonds.)

Because managers almost never spread the fund's money equally across every holding, along with checking a fund's total number of holdings, it's a good idea to check a fund's top 10 holdings to see what percentage of the assets are concentrated there. Even though a fund has 100 holdings, if the manager has committed half of the fund to the top 10, that fund could be a lot more volatile than one with the same number of holdings but less concentration at the top.

Evaluating operational risks

In addition to checking up on what risks lurk in a fund's portfolio, it's also worthwhile to consider any risks the fund might face at the operational level. Is there a chance the manager might leave, for example? Will a new fund-management company hike fees?

The good news for fund investors is that even if one of these risks becomes a reality, it's very unlikely it would affect the performance of a fund in short order. For example, if David Taylor left   Dynamic Value Fund of Canada  , shareholders would probably have good reason to head for the exits. But investors wouldn't have to decide right away because it would take a while for the new manager to put his imprint on the portfolio. Ditto for changes at the fund-company level, which tend to be more gradual than radical. Here's an overview of some of the key operational risks for fund holders.

Management and strategy changes --Actively managed mutual funds are only as good as the fund managers and analysts behind them. So a key risk factor for active funds is that the manager -- or worse yet, an entire management team -- would depart en masse. Keep an eye on who's running your fund, and if you notice a change, turn to Morningstar Analyst Reports for an assessment of whether investors should stay or go in the wake of a management departure.

It's also worth paying attention to whether a fund's strategy has morphed in the time that you've owned it. Strategy changes can be an even bigger cause for concern than a manager switch. They can be indication that a once-successful portfolio manager has lost confidence in his or her style, or that asset growth has altered the management's ability to invest in less-liquid securities. And in the worst-case scenario, frequent strategy shifts can indicate that a fund lacks a well-defined style and the manager is simply trying to adjust to what's working in the markets. As with manager changes, Morningstar Analyst Reports can help you gauge whether a strategy change marks a modest, worthwhile tweak or is something more worrisome.

Upheaval at the fund-company level --The past few years have brought massive changes at financial-services companies, with many smaller firms being gobbled up by larger entities. In the United States, some firms got themselves into regulatory hot water several years ago, and a steady outflow of investor assets has prompted them to cut personnel just to stay in business. There are no one-size-fits-all rules about which changes at a fund company should be considered red flags, but a short list of warning signs include mergers, management departure on a large scale, and regulatory run-ins.   Morningstar's Stewardship Grades attempt to summarize the gamut of factors that affect a fund company's health, and in turn its riskiness for shareholders.

Expense ratio increases --One risk factor to definitely stay attuned to is changes in a fund's management-expense ratio. If it's a fairly modest uptick--just a few basis points or so--an expense-ratio hike shouldn't set off alarm bells. But if a fund's expense ratio has jumped appreciably or expenses have headed up in drip-drop fashion over the space of a few years, that should be cause to investigate further. Costs are one of the key predictors of whether a fund will be a strong or poor performer versus others that invest in a similar way, so rising expense ratios are a risk factor you shouldn't ignore. Rising expenses may also be symptomatic of large-scale redemptions or a change in the firm's corporate culture or ownership, both risk factors in and o