Using Alpha in Managed Funds Selection |
Posted: October 29, 2014 |
Whilst there seems to be an abundance of ‘hot’ stock tips by investment advisory firms, financial magazines and newspapers, finance commentators and journalists, investors should tread cautiously. When making an investment decision the old adage “if it looks too good to be true, then it probably is” can all too often apply to many get rich quick investment schemes. In conjunction with commonly followed tips such as reviewing financial needs and goals, seeking independent financial advice, diversification, reviewing historical performance and making fee comparisons – it is recommended that investors begin to educate themselves on the more technical aspects of managed fund selection before investing. This means familiarising themselves with statistical analysis and the concepts frequently used in modern portfolio theory. It is not an understatement that investors are offered a wide range of choices and investment options - they can choose to invest passively or invest actively, a decision made easier with the right knowledge and information. Passive investing, such as investing in an index fund, has its pros and cons as is the case for actively managed investments such as an investment fund managed by a highly qualified and extremely proficient fund manager. Whilst there is a case for investing in an index fund (normally based on personal factors such as an investors risk tolerance and other beliefs) the philosophy behind actively managed funds is that some fund managers (also known as investment managers or portfolio managers) choose to deviate from the market portfolio and invest in other stocks with the aim of outperforming the market. Given there is plenty of evidence that supports the notion that there are in fact some fund managers that can successfully and consistently choose stocks that outperform the market portfolio, the theory that the market is perfectly efficient is refuted. What actively managed investments show us is that the skill and timing of the investment manager to buy and sell the correct stocks and assets for the portfolio plays a significant role in the success of a managed fund. Likewise, their lack of skill can then be attributed to its subsequent failure. So the question arises, how to measure a portfolio manager’s level of skill? It is measured using a commonly used statistical measurement tool known as ‘alpha.’ Whereas beta is a numerical value that represents portfolio risk - how much we would expect a portfolio to change when the market changes -alpha essentially measures an investment’s performance relative to the benchmark, such as the ASX200, or in other words, it primarily measures an investment manager’s level of skill or lack of it. Therefore, a positive alpha of 1.0 indicates that the managed fund has outperformed its benchmark index by 1%. Correspondingly, a negative alpha of 1.0 would suggest that it has underperformed by 1%. Thus the rule of thumb is that investors should select a managed fund with a positive alpha! ”While past performance is no guarantee of future performance there are numerous examples of Fund managers who, by following a disciplined process, have managed to consistently outperform both their peers and the benchmark.” Noted George Paxton, Fund Manager at APSEC Funds Management, whose fund, the Atlantic Pacific Australian Equity Fund, has returned 30.1% since inception (June 2013) Alpha can provide a clearer indication of how your fund manager performed and whether they added value or significant value to your portfolio but it shouldn’t be relied upon solely when making an investment decision. It is prudent that investors consider other metrics and factors, as cultivating knowledge on other forms of statistical analysis such as expense ratio and even beta, can further improve decision-making, helping investors to make more informed investment choices that will achieve higher rates of return on a more consistent basis.
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