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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