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The Alpha Advantage
By Craig L. Israelsen
From Financial Planning, September 2001
he quest for a variable which can foretell future performance is the modern day version of the search for the holy grail. One common variable, namely past performance, is certainly relevant in mutual fund selection, yet we all know that "past performance does not guarantee future performance." Such a disclaimer reminds us that the search for a predictive variable continues in earnest. This article suggests that alpha (one of the elements of modern portfolio theory) provides a relevant amount of predictive power in terms of mutual fund performance, particularly when bullish winds shift to bearish ones.
Morningstar describes alpha as "a measure of the difference between a fund's actual returns and its expected performance, given its level of risk as measured by beta. A positive alpha figure indicates the fund has performed better than its beta would predict. In contrast, a negative alpha indicates the fund's underperformance, given the expectations established by the fund's beta...". This definition suggests that beta has some degree of predictive power. Indeed, high beta funds are often selected for their potential ability to outperform the market. The obvious downside of this approach is when the market performs poorly and the high beta fund "outperforms" the market by declining even more.
Another variable which holds some promise as a predictive compass is Morningstar's Star Rating. As described by Morningstar, the "Risk?Adjusted Rating [or Star Rating] brings performance (returns) and risk together into one evaluation. To determine a fund's star rating for a given time period (three, five, or 10 years), the fund's Morningstar Risk Score is subtracted from its Morningstar Return Score. The result is plotted on a bell curve to determine the fund's rating for each time period: If the fund scores in the top 10% of its broad asset class (domestic stock, international stock, taxable bond, or municipal bond), it receives 5 stars (Highest); if it falls in the next 22.5% it receives 4 stars (Above Average); a place in the middle 35% earns 3 stars (Neutral); those lower still, in the next 22.5%, receive 2 stars (Below Average); and the bottom 10% get only 1 star (Lowest)."
Nevertheless, "Morningstar recognizes that no rating system can take into account all factors that one must consider before deciding to invest in a mutual fund. The Morningstar Risk?Adjusted Rating is intended as a way of identifying funds that have produced the highest level of returns relative to the risks they've taken. Investors should keep in mind that while it serves as an initial screen, the rating is only the first step toward a more comprehensive evaluation." As shown in Figure 1, there is a case to be made for including alpha as one of the variables to be considered in a comprehensive evaluation.
The funds in Figure 1 were all 5 star funds in the July, 1998 release of Morningstar's Principia Pro software. The logic for selecting only 5 star funds follows from the idea that this particular rating measure is often used as an initial filter when sorting mutual funds. Only non-redundant, non-index, large cap funds with at least 70% of their portfolios in U.S. stocks were included in the sample. It is important to note that the funds in Figure 1 are listed by their performance over the subsequent 3 years (from July, 1998 to June 2001). It is also worth noting that the three year period from 1995 to 1998 was a very robust period for large cap U.S. equities. The S&P 500 had a 3 year average return of 30.1%. The average return for the 71 funds from 1995-1998 was 30.7%. The following three years was a period of dramatically different results. From July 1998 to June 2001 the S&P 500 had an average return of 3.9% while the 71 funds in the sample had an average return of 3.5%.
Of the 71 funds with a 5 star rating in July, 1998 only three funds had a 5 star rating (3 year) as of July 2001. The average star rating for the 71 funds in July 2001 was 2.7. In the three subsequent years, eight funds fell from a 5 star rating to a 1 star rating. Clearly, as Morningstar suggests, the star rating is not intended as a predictive tool, but rather a starting point in selecting mutual funds.
We now turn our attention to the predictive potential of the alpha coefficient. Remember that the funds in Figure 1 are ranked by 3 year return over the period from 1998-2001, but the sample was originally selected based upon their star rating as of July 1998. The first quartile of funds during the 1998-2001 period had an average return of 9.3%, followed by quartile returns of 4.4%, 2.3% and -2.4%. The average 3 year star rating (as of July 2001) for the funds in the first quartile was 4.1, followed by quartile averages of 3.0, 2.2 and 1.5. As returns fell during the 3 year period from 1998-2001 so did many of the funds' star ratings.
As would be expected, funds with the highest returns from 1998-2001 also had the highest 3 year star ratings, lower beta coefficients, higher alpha coefficients, and higher Sharpe ratios. Standard deviation of return over the 3 years from 1998-2001 did not emerge as a variable which correlated with returns. These findings are hardly surprising because they are simply artifacts of the better performing funds looking back through time.
The worthwhile insight is the fact that the best funds (i.e. 1st quartile) in 2001 (based upon performance from July 1998 to June 2001) also had the highest alpha coefficients in 1998 (based upon performance from 1995-1998). The first quartile funds had an average alpha of 2.7 in July 1998 and a subsequent average three year return of 9.3% in July 2001. The finding is stable through each quartile. Better 3 year past performance as of 2001 can be traced back to funds with higher alpha scores in 1998 (based upon performance from 1995-1998). The inverse was found with regard to beta scores. The lower the beta in 1998 the better the performance over the next 3 years. Certainly, this is partly attributable to the fact that the three year period from 1998-2001 was a period of poorer returns among large cap stocks. Hence, lower beta funds would have the advantage.
As noted by Morningstar, the alpha coefficient is a measure of value which is added by a manager. While this assertion my be argued, it has been shown here that funds with higher alpha in the past tend to be funds with better performance in the future — particularly when the equity market turns sour. The sample of funds chosen for this study all had comparable 3 year performance as of July 1998 and were all rated as 5 star funds. However, the funds which best weathered the following three year period were those which had the highest alphas going into the storm. As I have observed previously, the value of management is seldom valued when market winds are favorable. It is only when contrary winds blow that many investors appreciate the stabilizing value of a solid equity fund manager. So, when filtering and selecting funds, utilizing alpha is probably a good bet.
Figure 1. The Case for Alpha
|
5
Star Large Cap Funds
as
of July 1998
(Ranked by 1998-2001 Return)
|
1995 - 1998
|
|
1998 - 2001
|
|
|
Return
3
Yr
|
Beta
3
Yr
|
Alpha
3
Yr
|
|
Return
3
Yr
|
Star
Rating 3 Yr
3
Yrrr
|
Beta
3
Yr
|
Alpha
3
Yr
|
Sharpe
Ratio
3
Yr
|
Std
Dev
3
Yr
|
|
|
|
|
|
|
|
|
|
|
|
|
|
PIMCO Renaissance B
|
29.8
|
0.84
|
3.2
|
|
15.3
|
5
|
0.74
|
11.3
|
0.51
|
22.6
|
|
Legg Mason Value Prime
|
39.4
|
1.08
|
5.7
|
|
13.7
|
5
|
1.18
|
10.6
|
0.34
|
27.9
|
|
Heritage Capital
Apprec C
|
30.5
|
0.89
|
2.7
|
|
13.1
|
5
|
1.03
|
9.2
|
0.37
|
23.9
|
|
Fidelity Sel Insurance
|
34.0
|
0.96
|
4.0
|
|
13.2
|
4
|
0.70
|
11.0
|
0.29
|
31.0
|
|
Fidelity Dividend
Growth
|
30.8
|
0.89
|
2.8
|
|
10.6
|
4
|
0.85
|
6.2
|
0.32
|
19.1
|
|
First Funds Growth
& Inc I
|
28.3
|
0.87
|
1.2
|
|
10.5
|
4
|
0.76
|
6.0
|
0.34
|
17.7
|
|
Elfun Trusts
|
28.6
|
0.89
|
1.0
|
|
9.0
|
4
|
0.85
|
4.7
|
0.23
|
18.5
|
|
Davis Financial A
|
37.5
|
0.89
|
8.2
|
|
8.9
|
4
|
0.98
|
6.0
|
0.16
|
27.1
|
|
Gabelli Westwood
Equity Ret
|
27.7
|
0.77
|
2.9
|
|
8.9
|
4
|
0.70
|
4.4
|
0.25
|
17.0
|
|
AHA Diversified Equity
|
28.7
|
0.91
|
0.8
|
|
8.9
|
4
|
0.94
|
4.9
|
0.20
|
20.8
|
|
Fidelity Sel Health
Care
|
32.1
|
0.85
|
5.0
|
|
7.9
|
4
|
0.40
|
3.9
|
0.15
|
19.6
|
|
First Eagle Fund of
Amer Y
|
33.2
|
0.84
|
5.9
|
|
7.4
|
4
|
0.73
|
3.1
|
0.13
|
18.1
|
|
SSgA Growth &
Income
|
29.2
|
0.99
|
-0.6
|
|
7.0
|
4
|
1.03
|
3.1
|
0.09
|
21.4
|
|
GE U.S. Equity Y
|
28.3
|
0.94
|
-0.3
|
|
6.8
|
4
|
0.88
|
2.6
|
0.10
|
18.4
|
|
General Elec S&S
Program
|
28.9
|
0.94
|
0.1
|
|
6.8
|
4
|
0.87
|
2.5
|
0.09
|
18.3
|
|
Sound Shore
|
28.3
|
0.84
|
2.1
|
|
6.4
|
4
|
0.61
|
2.3
|
0.07
|
18.6
|
|
Fidelity Sel Financial
Svcs
|
38.0
|
1.10
|
4.0
|
|
6.5
|
3
|
0.93
|
4.0
|
0.05
|
27.3
|
|
GMO Growth III
|
29.5
|
1.03
|
-1.0
|
|
6.5
|
3
|
1.29
|
4.3
|
0.05
|
29.9
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Quartile Average
|
31.3
|
0.92
|
2.7
|
|
9.3
|
4.1
|
0.86
|
5.6
|
0.2
|
22.1
|
|
|
|
|
|
|
|
|
|
|
|
|
|
INVESCO Financial Svcs
Inv
|
37.8
|
1.05
|
5.2
|
|
6.2
|
3
|
0.93
|
3.6
|
0.04
|
27.1
|
|
White Oak Growth Stock
|
35.0
|
1.33
|
-2.6
|
|
6.2
|
3
|
1.63
|
6.7
|
0.03
|
39.9
|
|
Fidelity
|
29.5
|
0.93
|
0.9
|
|
5.9
|
3
|
1.04
|
2.4
|
0.03
|
22.8
|
|
MFS Massachusetts Inv
Grth B
|
34.3
|
1.13
|
0.8
|
|
5.9
|
3
|
1.12
|
3.0
|
0.03
|
26.1
|
|
Rainier Core Equity
|
30.2
|
0.92
|
1.6
|
|
5.9
|
3
|
1.07
|
2.4
|
0.03
|
22.9
|
|
Wilshire Target Lrg Gr
Inv
|
32.0
|
1.14
|
-1.4
|
|
4.3
|
3
|
1.10
|
1.1
|
-0.05
|
24.1
|
|
Vanguard Windsor II
|
30.2
|
0.85
|
3.2
|
|
4.3
|
3
|
0.66
|
0.4
|
-0.06
|
18.7
|
|
Torray
|
35.4
|
0.87
|
7.0
|
|
4.1
|
3
|
0.91
|
0.7
|
-0.06
|
22.0
|
|
Preferred Large Cap
Value
|
27.8
|
0.84
|
1.5
|
|
4.1
|
3
|
0.79
|
0.3
|
-0.07
|
19.5
|
|
Fidelity Growth &
Income
|
28.5
|
0.88
|
1.3
|
|
4.1
|
3
|
0.80
|
-0.3
|
-0.08
|
16.4
|
|
Delaware Pooled Lg-Cap
ValEq
|
25.5
|
0.83
|
-0.1
|
|
4.0
|
3
|
0.59
|
-0.2
|
-0.09
|
17.5
|
|
Dreyfus Appreciation
|
31.1
|
0.96
|
1.6
|
|
3.9
|
3
|
0.80
|
-0.3
|
-0.09
|
17.3
|
|
BlackRock Index Equity
Instl
|
29.3
|
0.99
|
-0.6
|
|
3.7
|
3
|
1.00
|
-0.2
|
-0.09
|
19.7
|
|
State St Exchange
|
30.6
|
1.01
|
0.1
|
|
3.3
|
3
|
0.81
|
-1.0
|
-0.14
|
16.7
|
|
BlackRock Index Equity
Svc
|
26.8
|
0.83
|
0.9
|
|
3.3
|
3
|
1.00
|
-0.6
|
-0.12
|
19.7
|
|
BlackRock Large Cap
Val Inst
|
29.1
|
1.01
|
-1.1
|
|
3.2
|
3
|
0.67
|
-0.7
|
-0.13
|
18.2
|
|
American Cent Inc
& Grow Inv
|
31.3
|
0.97
|
1.4
|
|
3.2
|
3
|
0.99
|
-0.7
|
-0.13
|
19.7
|
|
Vintage Equity S
|
28.4
|
1.03
|
-2.1
|
|
3.1
|
3
|
1.09
|
-0.2
|
-0.11
|
22.6
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Quartile Average
|
30.7
|
0.98
|
1.0
|
|
4.4
|
3.0
|
0.94
|
0.9
|
-0.1
|
21.7
|
|
|
|
|
|
|
|
|
|
|
|
|
|
JP Morgan U.S. Equity
|
26.1
|
0.92
|
-1.6
|
|
2.8
|
3
|
1.08
|
-0.7
|
-0.13
|
21.6
|
|
McM Equity Investment
|
30.2
|
0.96
|
0.8
|
|
2.8
|
3
|
0.91
|
-1.3
|
-0.16
|
18.3
|
|
Hancock Indep Divers
Core II
|
28.9
|
1.00
|
-1.0
|
|
2.3
|
3
|
1.02
|
-1.4
|
-0.17
|
20.3
|
|
Fidelity Exchange
|
28.0
|
0.94
|
-0.4
|
|
2.3
|
3
|
0.71
|
-2.1
|
-0.23
|
15.2
|
|
Janus Twenty
|
35.9
|
1.15
|
1.6
|
|
4.6
|
2
|
1.42
|
4.1
|
-0.02
|
36.2
|
|
SunAmerica Growth
& Income B
|
30.2
|
0.84
|
3.5
|
|
3.3
|
2
|
1.09
|
0.1
|
-0.10
|
23.5
|
|
Stein Roe Young
Investor
|
32.9
|
0.97
|
2.9
|
|
2.9
|
2
|
1.16
|
0.3
|
-0.11
|
26.7
|
|
Domini Social Equity
|
30.3
|
1.05
|
-0.8
|
|
2.6
|
2
|
1.04
|
-1.0
|
-0.15
|
20.9
|
|
Goldman Sachs Core US
Eq A
|
28.2
|
0.98
|
-1.1
|
|
2.5
|
2
|
1.05
|
-1.2
|
-0.16
|
20.7
|
|
Dreyfus Disc Stock
|
30.7
|
1.03
|
-0.2
|
|
2.2
|
2
|
1.04
|
-1.5
|
-0.17
|
20.5
|
|
Dreyfus Premier Lrg Co
Stk A
|
30.5
|
0.97
|
0.8
|
|
2.1
|
2
|
1.03
|
-1.6
|
-0.18
|
20.4
|
|
Citizens Core Growth
Stndrd
|
31.8
|
1.11
|
-0.9
|
|
2.0
|
2
|
1.26
|
-0.5
|
-0.14
|
26.3
|
|
American Cent Equity
Gr Inv
|
32.0
|
0.99
|
1.7
|
|
2.0
|
2
|
1.03
|
-1.7
|
-0.19
|
20.6
|
|
Brinson U.S. Equity I
|
27.9
|
0.89
|
0.5
|
|
2.0
|
2
|
0.77
|
-1.9
|
-0.21
|
18.8
|
|
Enterprise Growth B
|
32.2
|
1.07
|
0.3
|
|
1.8
|
2
|
0.87
|
-2.0
|
-0.21
|
19.1
|
|
Northeast Investors
Growth
|
32.9
|
1.09
|
0.4
|
|
1.7
|
2
|
1.20
|
-1.2
|
-0.17
|
25.0
|
|
Firstar Growth &
Inc Ret A
|
30.2
|
0.76
|
5.3
|
|
1.2
|
2
|
0.78
|
-3.0
|
-0.30
|
16.1
|
|
Vanguard Growth Idx
|
33.3
|
1.08
|
0.8
|
|
1.0
|
2
|
1.13
|
-2.1
|
-0.22
|
23.4
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Quartile Average
|
30.7
|
0.99
|
0.7
|
|
2.3
|
2.2
|
1.03
|
-1.0
|
-0.2
|
21.9
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Performance Lg Cap Eq
Inst
|
31.3
|
0.96
|
1.7
|
|
0.8
|
2
|
0.92
|
-3.2
|
-0.29
|
18.0
|
|
Papp America-Abroad
|
27.6
|
0.99
|
-1.7
|
|
0.7
|
2
|
1.13
|
-2.4
|
-0.23
|
24.0
|
|
MFS Massachusetts Inv
A
|
31.3
|
0.92
|
2.6
|
|
0.3
|
2
|
0.83
|
-3.8
|
-0.35
|
16.5
|
|
SEI Instl Large Cap
Growth A
|
31.8
|
1.17
|
-2.3
|
|
0.3
|
2
|
1.40
|
-1.3
|
-0.19
|
30.1
|
|
SAFECO Equity
|
25.5
|
0.88
|
-1.3
|
|
-0.1
|
2
|
0.88
|
-4.1
|
-0.36
|
17.6
|
|
Diversified Inv Growth
& Inc
|
31.9
|
1.07
|
-0.0
|
|
-0.2
|
2
|
1.18
|
-3.1
|
-0.27
|
24.4
|
|
Sit Large Cap Growth
|
30.7
|
1.05
|
-0.7
|
|
-0.5
|
2
|
1.20
|
-3.1
|
-0.27
|
25.2
|
|
Accessor Growth Inv
|
29.6
|
1.04
|
-1.2
|
|
-1.1
|
2
|
1.17
|
-3.9
|
-0.31
|
24.2
|
|
BlackRock Select
Equity Svc
|
28.8
|
1.01
|
-1.4
|
|
-1.6
|
2
|
0.99
|
-5.3
|
-0.42
|
19.0
|
|
Putnam Investors M
|
31.0
|
1.08
|
-1.0
|
|
-0.8
|
1
|
1.19
|
-3.6
|
-0.29
|
24.5
|
|
Commerce Growth Instl
|
29.7
|
1.05
|
-1.4
|
|
-2.0
|
1
|
1.21
|
-4.8
|
-0.36
|
23.9
|
|
Pioneer Growth B
|
35.5
|
1.25
|
-0.8
|
|
-2.4
|
1
|
0.97
|
-5.9
|
-0.46
|
19.4
|
|
MFS Union Standard
Equity I
|
27.5
|
0.86
|
0.7
|
|
-5.2
|
1
|
0.75
|
-9.2
|
-0.82
|
15.1
|
|
SEI Instl Capital
Apprec A
|
28.4
|
0.94
|
-0.2
|
|
-5.3
|
1
|
1.21
|
-7.9
|
-0.53
|
23.6
|
|
Vanguard U.S. Growth
|
31.1
|
0.99
|
1.1
|
|
-6.5
|
1
|
1.39
|
-7.9
|
-0.49
|
28.5
|
|
Delaware Devon A
|
29.2
|
0.84
|
2.5
|
|
-7.2
|
1
|
0.83
|
-10.8
|
-0.87
|
17.0
|
|
HighMark Growth
Fiduciary
|
29.5
|
1.05
|
-1.6
|
|
-10.2
|
1
|
1.36
|
-11.6
|
-0.68
|
27.1
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Quartile
Average
|
30.0
|
1.01
|
-0.3
|
|
-2.4
|
1.5
|
1.09
|
-5.4
|
-0.4
|
22.2
|
|
Standard & Poor's 500 Return
|
30.1
|
|
|
|
3.9
|
|
|
|
|
|
|
Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
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