Individuals choose active diversified funds hoping to generate higher returns than benchmark index. The problem is that active management often underperforms the index. A question that most investors, hence, ask is: When is it good to take active exposure?

This article shows why individuals can be indifferent to market conditions while choosing active management. It then discusses issues relating to active management and explains why the appropriate question to ask is how to take active exposure, not when to take such exposure.

The objective of active management is to beat the benchmark index. The outperformance or excess return comes from security selection and market timing. Security selection involves selecting securities that are expected to do better than other constituents in the benchmark index. Market timing refers to loading high beta stocks during market uptrend and low beta stocks during market downtrend. The skill lies in expecting market turns and tilting the portfolio accordingly.

Let us take a situation where the benchmark index generates 10 per cent in one year and the portfolio with a beta of 1.25 generates 15 per cent return above the risk-free rate during the same period. The investors should then expect the fund to generate 12.5 per cent (1.25 x 10 per cent), as it has 25 per cent higher risk than the benchmark index (beta 1.25). The alpha then is 2.5 percentage points — difference between the excess return over the risk-free rate and the beta-adjusted expected return.

Extending this logic, a portfolio with high beta stocks may be generating higher return to compensate for the higher associated risk. We, nevertheless, consider market timing because it is an important driver of active management and has the similar characteristics as alpha.

Now, market timing and security selection can generate excess returns in up and down markets. During market uptrend, the portfolio manager generates excess returns by outperforming the benchmark index. During downtrend, such excess return is generated by losing less than the index. If an individual believes in active management, taking active exposure is not so much dependent on market conditions as it is on selecting a manager who can generate excess returns.

Alpha game

There are several characteristics of alpha that individuals should consider before deciding to take active exposure.

One, a portfolio manager can generate alpha due to luck or skill. Selecting the wrong manager would expose the individual's investment to high downside risk. Two, alpha is a zero-sum game. This means a portfolio manager who generates positive excess returns is doing so at the expense of unsuccessful active manager(s) who have underperformed the benchmark index. Alpha is highly risky, though rewarding.

Three, alpha gradually fades when many professional managers or when large sums of money “chase” the same strategy. This means that active management would be gainful if a portfolio manager simultaneously pursues several alpha strategies or quickly introduces a new strategy to substitute a fading alpha strategy. An individual does not know a mutual fund's alpha strategy, as it is not disclosed in the fund's correspondence to investors.

Four, alpha is measured as the excess return over the benchmark index. Individuals choosing a diversified fund should ensure that the benchmark is appropriate. A wrong benchmark could underplay the fund's associated risk and magnify the alpha returns. An active fund ought to outperform in an up and down market. There are few alpha-generating managers who can boast of such performance. The risk of choosing the wrong manager increases when dispersion among active funds is higher. If one were to believe in active management, the right question would be how to choose an active fund, not when not to choose one.

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