As financial advisors, we're always trying to find new ways of adding value to our clients' lives. Recently I examined my technique for constructing investment portfolios to ensure I was adding the most value possible. To begin my review I turned to alpha, which is commonly used to measure a mutual fund manager's performance. This is a significant statistic because it assesses if a particular fund manager has outperformed the market and realized a return in excess of a benchmark index; the same goals I try to accomplish for my clients. More importantly, alpha evaluates the investment skill attributed to a manager. As I began my investment review I soon wanted to know, as all advisors should, what's my alpha?

To find the alpha of a mutual fund, a required rate of return is determined through the Capital Asset Pricing Model and then variables such as expected market return, risk-free return and beta are input into an equation. The result is the fund's alpha, which is the actual return over and above that predicted by CAPM. When I construct a portfolio I want to combine a group of funds that will achieve the highest possible alpha. This ensures that I'm adding the right ingredients to the portfolio by selecting the best funds in the optimal amounts.

In trying to assemble the highest alpha portfolio, I may erroneously try to combine mutual funds with the highest individual alpha and maximize their percentages in the portfolio. This, in theory, should add the most value possible. However, if I rely only on each fund's alpha to assess which are the best fit, I'm likely not adding any value at all. The highest-alpha funds I select may impede the returns of others, cause overexposure to particular sectors or style boxes or negatively affect the portfolio if market conditions change. Very simply, the alpha of each fund says nothing as to how it will fit into a portfolio with others.

To find a better solution I examined my portfolio-creation process. When I assemble a portfolio I turn to a short list of 100 top funds that have made it through our firm's screening process. From the list I select eight to ten funds that meet the needs of a general type of client (i.e. age 40 with 20 years until retirement and investments of $1 million). Once I take into account the specific objectives of the client, I filter the available funds down to about ten and decide how to allocate each fund. At this point investing becomes more of an art than a science. Of the funds I've chosen, I have to select the quantity of each that will provide the right amount of risk exposure while still meeting the client's risk tolerance. What I need is a single statistical measure that tells me if I'm adding the correct percentage of each fund and adding the most value possible to the client's portfolio. I consider the evaluation of sector weightings, style boxes, historical returns, fund manager tenure and the Sharpe ratio to be critical when I construct a portfolio, but I also want to know how much of the overall performance is attributed only to skill (alpha), which can be a valuable and scarce commodity.

There is currently no measure that provides assurance that I'm utilizing the strengths of mutual fund managers and using their knowledge, combined with my own, to the maximum benefit of my clients. I need an alpha metric that solves the challenges I've presented, but is it obtainable? Not currently, in the simple form we want, but I've contacted portfolio management companies like Morningstar to work on this problem.

Even if such a statistic can be determined it will not negate the other factors we have to consider when constructing a portfolio, but as advisors we need to quantify what our investment planning acumen is achieving for our clients. More importantly, we need a measure that assures that our clients are getting the maximum benefit for their fee. In the years to come I predict advisors will use alpha as a basis for charging client fees. Under this system advisors with the highest alpha will command the highest fees and those with lowest amount of skill (the lowest alpha) will not be able to sustain themselves in the profession. In addition to the CFA and CFP® mark, the public will know if they're hiring a competent advisor based on their alpha rating.

Matthew M. Brandeburg is a planner with John E. Sestina and Company, a fee-only planning firm in Columbus, Ohio.