Portfolio Ideas. Choosing active mutual funds is no mean task

You prefer active funds to index funds. And why not? An active fund strives to give you higher positive returns than the benchmark index when the market is in an uptrend, and lower negative returns when the market is in a downtrend.

Of course, the challenge lies in identifying funds that generate such returns. In this article, we discuss why picking active funds is no small task.

Source of alpha

The excess returns that a portfolio generates over an appropriate benchmark is called alpha. Suppose a large-cap active fund generates a 15 per cent return, while its benchmark NSE 50 Index returns 14 per cent. The fund has generated an alpha of one percentage point. Importantly, the fund manager should have generated alpha, taking similar risk as the benchmark index.

Suffice it to know that a fund manager generates alpha through a combination of security selection and sector allocation.

The issue is that you will not know whether a fund has generated alpha predominantly through sector allocation or security selection because the information to dismantle a fund’s total returns is unavailable.

Why is the source of alpha important? A fund that generates its alpha predominantly through sector allocation has a higher chance of sustaining its alpha in the future. Consider this.

If you bet on SBI outperforming the NSE 50 index, you run the risk that it could underperform the index. However, if you bet on the banking sector outperforming other sectors in the NSE 50, your fund can still generate alpha even if some banking stocks in the index perform well.

Not knowing the source of alpha in a mutual fund is not the only problem. Another cause for concern is that alpha is not just about skill. It is also about luck. And you have to differentiate the two when you pick a mutual fund.

Luck and skill

Croatia may have been worthy runners-up in the 2018 FIFA World Cup, or the team could have been lucky. Of course, if Croatia consistently wins its matches, you can conclude that the team is skilful, not just lucky.

Each time Croatia played, you had evidence (or data point) to test your hypothesis as to whether the team was lucky or skilful. But with a fund manager, each such case or data point requires one year of performance.

And you need enough data points to conclude that a fund’s alpha is ‘statistically’ significant. The issue is that you may not often have enough data points to come to such a conclusion. That is not all.

Even a good team can fail — like Belgium or Portugal in the World Cup, if you consider them good. Likewise, a skilful manager can generate negative alpha. So, you now have a bigger issue: it is difficult to conclude if a fund’s positive alpha is a function of skill and luck or only luck.

Also, it is just as difficult to know if a fund’s negative alpha is due to a fund manager’s bad luck or lack of skill. And even if you somehow know all this, what if the fund manager leaves the asset management firm after you invest in the fund? So, you also have to determine if a fund has a sustainable alpha strategy that any fund manager can apply. But how can you determine that?

Given these challenges, there are two ways you can choose an active fund. You can hire an advisor who will test the sustainability of a fund’s alpha, or you can learn and do the sustainability test yourself.

But performance evaluation and attribution models only reduce the error of picking a wrong fund. So, if you find all this argument about choosing active funds complicated, you are not alone.

Remember, you can invest in an index fund for your goal-based portfolios.

The writer is founder

of Navera Consulting.

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