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Using 'Alpha' to Pick the Best Mutual Funds

NEW YORK ( TheStreet) -- Plenty of investors are abandoning actively managed mutual funds and shifting to index funds.

Investors figure that it's simply too hard to pick active winners. Just because a fund delivered double-digit returns in the past does not mean that it will repeat the performance in the future, their thinking goes.

But a growing number of research studies indicates that there are ways to pick winning actively managed funds.

The researchers suggest following risk-adjusted performance as measured by an indicator known as "alpha." By considering alpha, investors can compare a fund to its benchmark.

Say a fund takes as much risk as its benchmark, the S&P 500. While the S&P returns 10%, the fund returns 11%. The fund is said to have an alpha of 1.0. If the fund returns 9%, then it has an alpha of -1.0.

Alpha is particularly important because it tends to be persistent. If a fund had a positive alpha in the past, it is likely to have a positive alpha in the future.

Investors should pick funds with high alphas and below-average expenses, says a study by W. Van Harlow, director of research of Putnam Institute, which is funded by Putnam Investments, a fund company.

Van Harlow found that funds with high alphas have a 60% chance of outperforming peers in the future on a risk-adjusted basis.

Not many funds deliver high alphas. The average large blend fund has an alpha of -1.25. Clearly investors should steer away from average funds. But there is a small number of funds that have delivered high alphas over long periods of time.

Among the top performers are Weitz Partners III Opportunity Investor (WPOIX), which has an alpha of 9.68, Sequoia (SEQUX) with 6.25, and Hennessy Focus 30 (HFTFX) with 4.34.

Sequoia has a long track record for success. During the past decade, the fund returned 6.3% annually, outpacing the S&P 500 by 2 percentage points while taking much less risk than the benchmark as measured by an indicator called beta.

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