Funds' Success Not Just A Fluke
At the risk of stating the obvious, some fund managers are just better than others. One way to find top-flight managers is to simply compare fund returns. But smart investors factor in risk and performance-related metrics. To uncover effective portfolio managers, we looked for four key attributes:
Positive alpha. Alpha gauges the value a portfolio manager adds — or subtracts. The metric reflects the difference between a fund’s actual returns and its expected performance, as estimated using beta (a measure of sensitivity to market movements). The calculation is tedious, but you can find the figure at www.morningstar.com.
A positive alpha indicates a manager performed better than expected given the fund’s beta, while a negative alpha suggests a manager underperformed. For example, an alpha of 1.0 means a fund outperformed the beta-based return estimate by 1.0%. Alpha relies heavily on beta, which is only useful when much of a fund’s performance can be explained by movements in the broad market.
Lower volatility. To reward portfolio managers for keeping risk in check, we screened for funds with lower standard deviation than peers. Standard deviation measures how widely a fund’s monthly returns vary from the average monthly return. The higher the standard deviation, the wider the expected range of performance, implying greater volatility.
Positive information ratio. This reward-to-risk ratio compares a fund’s returns above an appropriate benchmark to its volatility, as measured by the standard deviation of the fund’s monthly excess returns relative to the benchmark. The ratio, calculated by Morningstar, helps gauge whether performance is driven by savvy portfolio management or taking on extra risk.
Solid, consistent relative performance. We looked for funds with three- and five-year returns above category averages. We also looked for funds that outpaced averages in at least two of the last three years.
The four top picks listed above, all members of our recommended fund portfolios, rank well based on all four of these measurements. Standouts include T. Rowe Price International Discovery ($30; PRIDX), which ranks among the top 28% of its peer group for one- , three- , five- , and 10-year total return. Longtime portfolio manager Justin Thomson invests in small and midsized foreign companies. Vanguard Dividend Growth ($11; VDIGX) invests primarily in large-cap stocks. Portfolio manager Donald Kilbride took the helm in early 2006, steering the fund to better-than-average returns in each of the last three years. Full-term subscribers may obtain reports on covered funds on our Web site by clicking on the name of the fund in the dropdown menu above.