Defining Our Fund Universe
To define our universe, we screened first on fu
nds with the term "Alpha" in their names, on the theory that if a fund is making a claim to deliver positive alpha, it should be tested. We next screened on funds with fewer than 35 holdings or more than 50% of assets in their top 10 holdings to capture those whose portfolios are highly concentrated relative to market benchmarks.
Where's the Alpha in High Alpha?
A first look is not encouraging--we calculated Jensen's Alpha over the past three years relative to the FTSE All Share (Merrill Lynch GBP Libor 1 Month Constant Maturity was used as a proxy for the risk-free rate), and found that only 12 of the 38 funds with three-year records delivered positive alpha in the period. The picture was exactly the same relative to the FTSE 100. So less than a third of funds that were either highly focussed or make a claim to have an alpha-oriented approach actually came through. If we look at just those funds with alpha in their names, the picture is slightly better: four of ten delivered positive alpha in the period. The picture improves, however, if you compare the hit rate to the broader UK All Companies sector: In the broader group, 38 of 179 funds (we excluded pure mid-cap offerings and pure FTSE 100 offerings on the grounds that measuring their alpha relative to the All Share is a meaningless exercise), or just 21%, delivered positive alphas versus the All Share.
Focussed Funds: Key Take Aways
What's very clear is that extremely few funds have managed to deliver the goods in UK All Companies, but that your odds were slightly better with a focussed offering. So, should you rush out to buy a focussed fund? Not so fast. First, there's the risk issue: As a group, the funds have a higher standard deviation of returns than the broader sector, and their exposure to issue-specific fundamental risk is by definition above average. Moreover, picking a fund that has produced high alpha in the past does not necessarily mean it will do so going forward--in fact, like most past performance measure, it's a relatively poor predictor of future outperformance. If we look at the funds within our select group that have top quartile three-year alphas today, only one of them was in the top quartile three years ago. The results are similar for the broader UK All Companies sector: Of the 45 funds in the top quartile by three-year alpha over the past three years, only 14 of them were in the top quartile three years ago, and 12 of them were in the bottom quartile at the time.
Two Focussed Funds We Like
Bearing those risks in mind, there are still some funds in the group we think have merit. One of these is Robert Churchlow's L&G Growth Trust, which features a roughly equally weighted portfolio of 25 shares (you can read our new qualitative analysis of this fund here). Churchlow has accomplished a lot here--even though a decision to underweight mining cost the fund in 2007, he helped offset that by limiting the fund's exposure to banks and consumer issues, and has delivered excellent results over time. We also think highly of Richard Buxton's Schroder UK Alpha Plus. The fund is higher risk and not suitable as a core holding in our view, but Buxton's experience gives us comfort with the fund's strategy, and he's showed a real knack for adding value during his tenure (click here to see our qualitative research on this fund).
A version of this article previously appeared in Investment Adviser, Financial Times Ltd.
