By Andy Lawson, Ph.D.
The short answer: Positive risk-adjusted returns, stable risk exposures, long management tenure, diversification and moderate turnover.
• Positive risk-adjusted returns, or alphas. A fund with positive alphas adds value by delivering returns in excess of those expected from the fund given the fund's risk exposures. In contrast, a fund with zero alphas behaves like an index fund by earning returns exactly commensurate with the amount of risk it is taking on. A fund with negative alphas underperforms by earning returns which don't compensate investors for the risk they are exposing themselves to by investing in the fund and therefore a negative-alpha fund should be generally be avoided.
• Stable risk exposures (consistent investment style). A fund's risk is generated by its exposures to risk factors in stock and bond markets. Drift or shift in a fund’s risk exposures over time may indicate an inconsistent investment strategy. Also, a fund with drifting or shifting risk exposures tends to contribute more risk to an investor's overall portfolio than a fund with consistent exposures.
• Management tenure. AlphaFunds evaluates a fund using at least 36 months of historical data. We can expect the evaluation to be more informative if the fund's management team has not changed over the evaluation period (after all, how much faith would we have in an assessment of a fund based on the fund's track record over the prior 5 years if the management team changed last quarter?). This suggests requiring a fund's management tenure to be at least 36 months.
• Diversification. A diversified fund has exposure only to market risk while an undiversified fund has exposure to both market risk and non-market risk. Since exposure to non-market risk is not compensated, a fund with exposure to only market risk (a fund which is diversified) tends to be less risky than a fund with exposure to both market and non-market risk. One way to increase the chance of diversification is to require funds to have at least 50 positions.
Note that the more funds your portfolio contains, the less important it is for each fund to be diversified. This is because the other funds in your portfolio will diversify away the non-market risk in any undiversified fund. This is the case even if all funds in the portfolio are undiversified. So if you are building a portfolio of just one or two funds, your portfolio will not be diversified unless each of the funds is diversified. However, if you are building a portfolio with eight funds, your portfolio will probably be diversified even if each of the funds in it is undiversified.
• Net assets. Funds with a larger amount of net assets have a higher chance of being well-established than funds with a smaller amount of net assets. It therefore may be prudent to require funds to have at least $100 million in net assets.
• Turnover. For portfolios which are not tax-sheltered, funds which frequently realize returns by selling stocks or bonds tend to be less tax-efficient than funds which sell less frequently. One way to identify funds which are more tax-efficient is to require funds to have a turnover rate which is below the stock or bond fund median.
