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The Alpha Bet: Figuring Which Mutual Fund Managers to Back

Mutual fund managers - not their hedge fund counterparts - are the original alpha males (and females).

To measure the "alpha" produced by a mutual fund manager, the basic risks of the type of fund being run are captured in a benchmark index. Any return achieved by the manager beyond the benchmark is his (or her) alpha.

Last week, a Texas investment software firm introduced a set of online tools that let small- and medium-sized advisers as well as pension plan sponsors, banks or money managers calculate and compare the alpha achieved every month by different mutual fund managers.

The suite of tools from EMA Softech in the Dallas suburb of Plano is not surprisingly called AlphaFunds.

The tools use the kind of formulas typically used by large institutions in pricing assets based on multiple risk factors. The firm's director of research, Andy Lawson, boasts that the suite "harnesses the full power of modern financial economics while being easier to use." Easier than what is left open to question.

But here's how it works: A benchmark index is created for any individual fund, that mathematically captures how the portfolio of stocks (or other assets) would perform if managed passively.

The three main factors that are weighed and weighted are:

* General market risk, which quantifies the premium that must be paid to satisfy investors for putting their money in, say, components of the Wilshire 5000 Index as opposed to a U.S. Treasury bill.

* Size risk, where investors demand compensation for taking chances on smaller stocks, whose prices gyrate more widely than large stocks; and,

* Value risk, where investors generally seek and get bigger returns for so-called value stocks, because, as Lawson puts it, they are in for a "rougher ride" than with growth stocks.

"The name of the game is to multiply the risk estimates by the risk premiums" that investors expect, Lawson said. The estimates of risk in each of the three main factors of analysis vary by the kinds of stocks or other assets in the fund. The risk premiums also vary.

There is a fourth factor that EMA Softech adds to its creation of each benchmark index, which acknowledges that stocks with greater momentum-more price gains-than other stocks may be closer to reaching their full value. But the impact on the overall index is fairly minimal, Lawson, a statistician, notes.

In any event, the AlphaFunds tool then monitors the fund's actual performance. The passive results of the benchmark index are subtracted from the active results achieved by the fund manager. If the fund's value exceeds the benchmark, there is alpha. And if not, not.

The tool though doesn't simply supply a static shot of a fund manager's performance. The performance is tracked over time, by month and year. And a user can easily pick as many funds as wanted (and thereby, managers) to compare performance and get a sense of effectiveness, long-term. In the Pernassus Equity Fund example here, the time series for 2001 through 2010 on its alpha shows that the manager has been fairly consistently successful.

Only in two years was the fund's alpha negative and then never by more than 2%. This is good, Lawson says. You would not want "lumpy" performance by a manager.

The blue bars next to the alpha time series [in print edition] show how a manager's alpha compares to the alphas of other fund managers. Here, this manager has ranked above nearly all other managers in a fund's peer group, in recent months. He was in the top percentile two quarters ago and still is above 90% of other managers, in the amount of alpha he produces. He's a steady, proven performer, right now at the top of his game.

That kind of clear visual expression of performance can be "actionable," Lawson says. For instance, if the manager falls into the lower 50% of managers in his peer group three quarters in a row, it's probably a good sign that something has gone wrong with either his strategy or his execution of it. Time to consider moving money elsewhere.

The math works much better for comparing mutual fund managers, than hedge fund managers, Lawson contends. "The beauty is the alpha you get with mutual funds is much more precise than for hedge funds,'' he argues. "Mutual funds by and large have a narrower brief," or mission, than hedge funds, which tend to operate in a wider array of more exotic investments, than the stocks and bonds that are the foundation of mutual funds.

This "narrower brief" makes it "easier to evaluate" the risks and performance of each fund.