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| The Basics | 22 hot funds that should stay hot
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Harry Markowitz and William Sharpe revolutionized investing with their work on statistical analysis and portfolio theory. Use their work to find funds that consistently beat the market.
By Harry Domash
Many investors get burned by relying solely on historical returns when picking mutual funds. They find out that, in many cases, last year's hot fund is this year's dog.
But history can be a great guide, provided you know how to apply it. Heres a method for finding funds that uses advanced fund-selection principles from groundbreaking research by Harry M. Markowitz and William F. Sharpe, winners (with Merton H. Miller) of the 1990 Nobel Memorial Prize in economics.
Starting in the 1960s, Markowitz and Sharpe helped turn the investment world upside down by developing concepts based on sophisticated statistical analysis techniques that evolved into theories known as Modern Portfolio Theory and the Capital Asset Pricing Model.
Not everyone buys their ideas for picking stocks. But when it comes to mutual funds, their concepts have found wide acceptance.
Ive found one fund performance measure from their work, alpha, to be especially useful for spotlighting market-beating funds. Using it effectively, though, requires that other factors fall into place. Fortunately, MSNs Deluxe Fund Screener can search for everything needed to do the job. Ill explain more as I describe my alpha screen.
Alpha-beta soup
First, a couple of definitions.
Beta: This measures a funds recent returns compared with the overall market. A beta of one means that the fund moved in sync with the market, and by the same amount. For instance, the market and fund both gained 10%. A beta of two means that the fund moved in the same direction as the market, doubling its return.
Alpha: This measures a funds return in excess of what it should have returned given its beta. If a funds beta is one, it would be expected to move in concert with the S&P 500. But, say the fund gained 15% in a period when the S&P 500 was flat. In that case, the funds alpha is 15 because it returned 15% more than its beta predicted. Alpha is negative if the fund performed worse than the S&P index.
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In practice, many consider alpha a measure of a fund managers stockpicking prowess.
While its a controversial topic, some research, including my own, finds that high-alpha managers often continue their winning ways. In my experience, even though alpha measures historical performance, a portfolio of high-alpha funds picked today will likely outperform a similar portfolio of low-alpha funds.
According to Morningstar, fund alphas currently range from as low as negative 11 to as high as 45. The average alpha of all funds is close to two. Obviously, the higher the better. I arbitrarily set my minimum at 10. Consider dropping the threshold to as low as six if your screen doesnt turn up enough funds.
Screening Parameter: Alpha >= 10
Hot funds, by definition, can be risky business, so ruling out the chanciest players is the next priority.
Get Sharpe
William Sharpe came up with a simple way of measuring a mutual funds risk-adjusted performance, now known as the Sharpe ratio. The Sharpe ratio compares a funds excess return to its risk.
Excess return is the funds return over and above what you could obtain by putting your money in a no-risk investment, specifically, 90-day U.S. Treasurys. For risk, Sharpe used standard deviation, which is a volatility measure. So the Sharpe ratio is the funds return minus the return on 90-day Treasury bills, all divided by the funds standard deviation.
According to Morningstar data, Sharpe ratio values currently range from -1.7 to 2.5. If you were using the Sharpe ratio by itself to select funds, higher would be better. However, here, Im using alpha to pick the funds and the Sharpe ratio to rule out the riskiest players. So, I set my minimum at 1.0, which only is moderately above the 0.9 average of all funds.
Screening Parameter: Sharpe Ratio >=1
Not all alphas work
The way the math works, alpha isnt meaningful for funds whose share-price movement doesnt correlate, within reason, to an index. For instance, the computed alpha isnt meaningful if the funds share price typically moves up when the index drops and vice versa.
The measure of a funds share price correlation to an index carries a name that only a statistician could love: r-squared. The range of r-squared is 0 to 100, where 100 means the funds price action correlates perfectly with the index. Zero means the two are entirely unrelated.
I require a minimum 60 r-squared. Thats as low as you want to go. Increase the minimum to as high as 75 if you get too many hits.
Screening Parameter: r-Squared >= 60
Since alpha is all about the fund managers stockpicking skills, all bets are off if the manager leaves. MSNs alpha is calculated using three-year data, so thats the figure I use for minimum manager tenure.
Screening Parameter: Manager Tenure >= 3 years
The alpha and Sharpe ratio measures apply primarily to stocks funds. Consequently, I require funds that hold mostly stocks, as opposed to bonds or cash.
Screening Parameter: Percent Stocks >= 80
Funds you can buy
Theres no point in evaluating funds that you cant buy. So, I added three screening parameters to rule out funds that are closed to new investors, that cater exclusively to institutional investors or that require a minimum initial investment higher than you can handle.
Screening Parameter: Closed to New Investors = False
Screening Parameter: Institutional = False
Screening Parameter: Minimum Initial Purchase <= 3,000
Revise the minimum purchase requirement to suit your needs.
Finally, since youre picking your own funds, there is no point in paying a load, another word for sales commission.
Screening Parameter: Front Load = 0
Screening Parameter: Deferred Sales Charge = 0
My screen listed a few funds that were closed to new investors, although in theory they should not have shown up. After deleting those funds I was left with 22 high-alpha funds. Surprisingly, a few fund families dominated the list. Royce Funds and T. Rowe Price were represented by three funds apiece. American Century, Baron Funds and Laudus Funds each had two funds on the list.
| | | Fund Name | | Alpha | | American Century Utilities Adv (ACUTX) | | 10.8 | | American Century Utilities Inv (BULIX) | | 11.1 | | Artisan Mid Cap Value (ARTQX) | | 14.0 | | Baron iOpportunity (BIOPX) | | 15.6 | | Baron Partners (BPTRX) | | 13.3 | | CNI Charter RCB Sm Cap Val A (RCBAX) | | 10.3 | | Excelsior Emerging Markets (UMEMX) | | 11.0 | | HighMark Small Cap Value Fid (HMSCX) | | 11.3 | | Hodges (HDPMX) | | 14.4 | | Jacob Internet (JAMFX) | | 21.7 | | Laudus Rosenberg Intl Small Cap Inv (RISIX) | | 12.5 | | Laudus Rosenberg U.S. Discovery Inv (RDIVX) | | 10.2 | | Pennsylvania Mutual Inv (PENNX) | | 10.6 | | Royce Premier Inv (RYPRX) | | 10.8 | | Royce Value Inv (RYVFX) | | 16.3 | | Royce Value Plus Inv (RYVPX) | | 17.9 | | Scudder Emerging Markets AARP (SEMMX) | | 10.7 | | T. Rowe Price Emerging Markets Stock (PRMSX) | | 10.3 | | T. Rowe Price International Discovery (PRIDX) | | 11.0 | | T. Rowe Price New Horizons (PRNHX) | | 10.3 | | Vanguard Strategic Equity (VSEQX) | | 10.1 | | Westcore Mid-Cap Value (WTMCX) | | 10.9 |
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At the time of publication, Harry Domash did not own or control any of the funds mentioned in the article.
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