Alpha Dogs

Dedicated followers of the Clipper Fund may have been dismayed when longtime managers James Gipson and Michael Sandler left the fund recently. For many investors, the Clipper crew represented the best in value investing. During the past decade, the fund returned 13.9 percent annually, outdoing the S&P 500 stock index by 4 percentage points, and surpassing 98 percent of large value funds. But shareholders may be better off without the old management team. On a risk-adjusted basis, Clipper looks like a shaky vessel. The fund posted an alpha rating of -6.06, well below average for the large value category. (Alpha measures a portfolio's returns considering the risk it took; the higher the number — a positive one — the better.) In the case of Clipper, the fund delivered big returns — but took unacceptable risk to get them.

Clipper routinely placed big bets. In a concentrated portfolio with less than 30 holdings, the fund took sizable positions in stocks selling at deep discounts. Because those holdings were unloved, it often took years for the bets to pay off. And when a big position or two proved unsound, the portfolio took a big hit. “If you are going to buy a deep-value fund like Clipper, you have to be prepared to wait years for results, and not all clients can do that,” says Ross Levin, president of Accredited Investors, an investment advisor in Minneapolis.

Check Under the Hood

To protect clients, advisors should consider funds with steady results and strong risk-adjusted returns. Sounds obvious, right? But doing so may mean taking a pass on a fund with gaudy returns. Big returns often equate big risks. But you can get strong returns with reasonable risk. Avoiding peaks and valleys, and searching for consistent funds that enable investors to patiently stick with long-term asset allocations is the best formula for success. “If two funds have similar returns, then you should pick the one with more consistent results,” says Roseanne Pane, mutual fund strategist for Standard & Poor's. Yet advisors too often recommend unacceptably risky, albeit “successful,” funds. (How often do you merely discuss absolute returns with clients instead of “risk-adjusted?”)

We're not singling out Clipper for taking unacceptable risks. Another overrated star has been Ameristock, a large value fund. The fund came onto the map when it produced a return of 20.7 percent in 2000. Investors took notice and assets grew from $164 million in 2000 to $1.3 billion in 2001. During the past five years, Ameristock has outdone the S&P 500 by a sizable margin. Like Clipper, Ameristock has a yen for concentration: The fund holds about 40 percent of its assets in its top 10 holdings. That is a sizable bet to place on so few stocks, especially unloved ones. As a result, Ameristock has posted an alpha of -3.7 (see table).

Risk-adjusted results expose problems with American Funds' Washington Mutual Investors, one of the biggest large value funds with $62 billion in assets. The fund has outdone the S&P 500 during the past decade by holding dividend-paying blue chips. In downturns, the unloved blue chips shine, but they often lag during other stretches. The value fund has an alpha of -0.2, well below the category average. Like Clipper, Washington Mutual buys deeply out-of-favor stocks and holds them for years. In recent years, Washington has owned unloved health stocks like Bristol-Myers Squibb. Those may revive eventually, but so far they have languished.

Simply controlling risk does not result in strong alpha. A fund must also deliver healthy returns. Franklin Equity Income A is a large value fund that has outpaced the S&P, but it has posted an alpha of -1.4. The fund has remained extremely cautious, sticking with dividend-paying blue chips. But clients may get better risk-adjusted returns with an index fund with better risk-adjusted returns.

It's not just value funds that can produce poor risk-adjusted returns; it occurs in all asset classes. The issue can be particularly acute in concentrated portfolios. Even if the long-term returns are solid, investors may face lengthy periods of disappointment.

Consider Enterprise Growth A, a fund with $1.4 billion in assets that has outperformed 88 percent of its competitors in the past five years. The growth fund buys about 40 large blue chips and holds them for years. That approach lagged in the late 1990s, and hurt again in 2003 and 2004 and has posted a below-par alpha of -3.8. The fund tilts toward the biggest stocks, posting an average market capitalization of more than $50 billion.

As its name suggests, Fidelity Fifty holds a concentrated portfolio of stocks with rapid earnings growth. The fund holds big stakes in a few sectors, including software and business services. The formula has produced strong returns but outsized risk. The alpha is a lowly -2.8. Another concentrated large growth choice is Smith Barney Large Cap Growth, which has $5.6 billion in assets and posts an alpha of -0.5. The fund owns about 30 stocks with strong earnings growth. The fund has big stakes in pricey hardware and media stocks. Once Smith Barney buys, it hardly ever sells; annual turnover is 5 percent. The returns have been decent over the past five years, but the ride is sometimes bumpy.

Another low-turnover, large growth choice is T. Rowe Price Tax-Efficient Growth. The fund purchases blue chips and rarely sells, a strategy that holds down tax bills. The portfolio includes such powerhouses as General Electric, Dell and Microsoft, sensible holdings for long-term investors. But with giant blue chips out of favor, the tax-efficient portfolio posted an alpha of -3.1.

With markets shunning large-cap stocks, mid-cap funds have shown bigger returns. But not all the top performers can boast strong risk-adjusted results. American Century Veedot, a mid-cap growth fund, has beaten its benchmark but posted an alpha of 1.9, compared to the 4.4 average figure for its category. The fund trades rapidly, hoping to catch fast-growing stocks just before they skyrocket and show real velocity. Quantitative screens seek stocks with the best accelerating earnings. That approach can be erratic.

Fidelity New Millennium, which has $3.3 billion in assets, has traveled a rough route through the mid-cap growth universe. The fund looks for high-growth names, and sometimes makes big bets on particular sectors. Those sometimes backfire. A sizable stake in data-storage companies proved off the mark. The erratic performance produces the sort of mixed risk-adjusted returns that many investors may want to avoid.

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