Knowing how to measure a fund's risk level has long been a basic requirement for professional fund managers. But smaller investors need to know too.
The Association of Investment Trust Companies breaks investment trusts into categories. Some categories are generally thought of as high-risk, such as emerging markets. But things are not that simple.
SBC Warburg publishes A Private Investor Guide to Investment Trusts. This gives trusts a low, medium or high risk label. Using its ratings, the guide tries to show that, for example, a fund in a traditionally high- risk category such as emerging markets may be lower risk because of its specific investment strategy.
"It's very important [to rate a fund for risk], because within a particular sector you might think you're dealing with like for like but one fund manager could be dealing with small stocks while another is buying blue chips," says Christine Ross of Abbey National IFA, the bank's independent financial advice arm.
"The past performance may be good, but what are the potential pitfalls?" she asks. Abbey National IFA has started rating investments in its own reports, giving them a mark out of 10 for risk. A building society deposit account is given a one, while Perpetual's UK Growth fund has a seven. With unit trusts, the mark is based on volatility, or standard deviation. Volatility shows how smoothly the price of units in a fund has risen. It is a measure derived from the changes to an investment fund's price over a certainperiod.
You can find out from an independent financial adviser what the volatility of a certain fund has been, or you can find the figures for yourself in specialist financial information publications such as MoneyFacts, which uses volatility numbers from performance data provider HSW.
Micropal, another performance data supplier, has its own system of star ratings for investment funds. These are based on a ratio of relative return and price volatility. But you have to look at these ratings carefully, because a high-performing fund which has been volatile might get a similar rating to one which has performed poorly but has low volatility. Micropal's star ratings appear in specialist publication Money Management.
Soaring performers in the league tables can come down to earth with a jolt if you take risk factors into account. Ms Ross points out that Prolific Technology, a top-performing unit trust, shines in the five-year performance tables. Annual returns average a massive 29 percent. But when the league table is adjusted for risk, Prolific Technology falls to 59th place, with Jupiter Income taking first place.
There are many other key factors when judging just how risky an investment is. For instance, the fund's price may have been relatively steady in the past, but if the fund manager has just changed or the fund's size has grown rapidly, this might change.
Ian Millward, investment marketing director at IFA firm Chase de Vere, says ratings from Standard and Poor's Fund Research is a starting point when recommending unit trusts to clients. It has a rating system which looks at a range of factors. S&P interviews fund managers to get a close look at the way investors' money is being used. Before they are included in the rating system, funds are filtered using tests such as how consistent their performance has been. Funds which are included are given the highest rating of AAA, middle rating of AA or least high rating of A. The company's researchers look at factors such as how well a fund has done compared to the rest of its sector and how many different shareholdings it has. It also scrutinises volatility levels.
"Most investors just look at the charts to see which the best fund is and go with that," says Mr Millard. "But it should be a case of matching your investment attitude to risk with that of the fund."