Mutual funds should not be evaluated solely on the basis of returns. It is equally important to consider risk.

Consider the example of American Funds American Mutual (AMRFX). The fund is run in a conservative manner, with a focus on safe stocks and downside protection. Unsurprisingly, the funds five year results are middling amid one of the biggest bull markets in history, trailing 60% of Morningstars Large Cap Value category. On a risk-adjusted basis, however, the fund looks much better, landing in the top 10% of its category (chart below). Although the fund has trailed peers in a strong bull market, its modest risk profile may allow the fund to exhibit less downside during a bear market.

In contrast, many funds that have performed very well over the past five years are more aggressive in their approach. These funds may struggle during the next bear market.