When it comes to the art and science of managing any portfolio, risk is almost always the first consideration. And far too often, analysts say, the Average Joe does a poor job of balancing risk throughout his portfolio, either playing it too safe for his expected investment timeline or exposing himself to far too much of it in the hope of making a quick killing.

Fortunately, most people rely on a professional advisor to help them navigate potential landmines while also putting a reasonable portion of their portfolios into funds and individual stocks that bring some inherent volatility along with some prodigious returns.

With this general theme as a backdrop, S&P equity analyst Ari Bensigner this week put out a report based on some research of S&P's top-rated, large-cap mutual funds that delivered better returns than the rest of the peer group but also carried a higher degree of risk.

Keep in mind, risk is relative.

For starters, we're talking about four-star funds from the large-cap growth universe (840 in total) so these aren't the roller-coaster-like emerging market or small-cap funds. These are solid, stable funds that also just happen to have -- based on standard deviation and other measures -- slightly more risk, historically, than their peers.

After poring over the data, two funds stood out from the pack: Columbia Select Large Cap Growth Fund; A (ELGAX) and Morgan Stanley Focus Growth Fund; A (AMOAX).

Over the past three years, Morgan Stanley Focus Growth and Columbia Select Large Cap Growth outperformed their large-cap peers by 400 basis points and 250 basis points, respectively.

Bensinger used standard deviation, essentially a historical measure of the variability of a fund's return, as the starting point for qualifying these "riskier" funds.

Also, to account for the fund's professional management skills, the research incorporated the Sharpe Ratio -- a fairly complicated formula that measures the fund's historical return adjusted for risk and volatility.

In other words, the formula calculates if a fund is delivering the expected superior returns relative to its risk -- similar to the way a craps player would expect a hard "8" to return a better payoff compared to an easy "8" acknowledging that it's much harder to roll a pair of fours. But if you're losing at the same rate or winning at the same rate -- or at roughly the same rate -- there's little point playing it safe hoping for a "2" and a "6" or a "3" and a "5."

Using this methodology, a fund was rewarded for having a high Sharpe ratio versus its peers -- it performed better on a risk-adjusted basis. Only the cream of the crop, by S&P's estimation, of large-cap funds were in consideration and they all had more than $1 billion in net assets, a standard deviation of more than 10% above the mean and had a Sharpe ratio at least 50% higher than the peer average.

Large-caps were selected not only because of their popularity among both institutional and retail clients but also because S&P and other firms contend that large-cap stocks and funds tend to outperform others in the second and third years of a bull run, which is where we are today.

"If you're investing in more aggressive funds and risky funds, you have to be willing to live with the short-term ups and downs of the fund," said Dylan Cathers, an S&P mutual fund analyst. "We thought it would be interesting to take a look at some at some of these funds to see if there were some that would be worth investors taking on a little extra risk and these two popped up."

The top 10 holdings quality rank, in S&P's evaluation, for Morgan Stanley Focus Growth Fund only garners a "C." It's a 31-stock fund heavy on tech stocks (31%) and consumer discretionary stocks (26%) that had one-year, three-year, five-year and 10-year average annualized returns that were ranked in the top quartile against peers and a Sharpe ratio of 0.35 -- almost double the peer average.

"Looking deeper at the portfolio, we see a number of stocks considered undervalued by S&P equity analysts but having what we view as less stable or short earnings and dividends records," Bensinger wrote.

That makes sense considering S&P uses 10 years worth of performance and data to value the stocks and funds it tracks and this fund includes Google (NASDAQ: GOOG) which went public in 2004. It also includes Apple (NASDAQ: AAPL) and Illumina (NASDAQ: ILMN).

It's noteworthy that this fund was ranked 681 out of 687 large-cap funds in performance in 2008 but rose to second out of 731 in 2009 and sixth out of 780 last year.

Columbia Select Large Cap Growth, meanwhile, checked in with a Sharpe ratio of 0.30, again well above the 0.19 peer average and standard deviation of 24.9 compared to the peer average of 22.

Regardless, this relatively new fund (created in 2007) still brought back 250 basis points more than its peers and landed in the top quartile compared to its peers for one-year and three-year returns. Also a 31-stock fund, it also includes Apple and Allergan (NYSE: AGN) and roughly 30% of its components are tech stocks.

"These two mutual funds have incurred risk but still are worthy of consideration, in our view, for their high Sharpe ratios and other factors," Bensinger wrote. "But investors should be mindful that some funds that swing for the fences will strike out."


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