For most of you, the lure of beating a benchmark index is too tempting to pass. And so, most of you search for active funds to invest in. In this article, we discuss the characteristics of alpha — the factor that embodies an active fund — to explain why choosing active funds can be so challenging.

Alpha game The excess return that an active fund generates over its appropriate benchmark index is called the alpha. Your investment decisions would be better if you appreciate the characteristics of alpha.

Consider large-cap portfolios. Some active large-cap funds will generate higher returns than the NSE 50 Index, while others may underperform. The sum of positive alphas of all the above-average market participants should equal the sum of negative alphas of all the below-average market participants. This argument typically holds for the entire market, but may be difficult to prove for just the large-cap universe. Why? Some market participants may invest in large-cap stocks. But their alpha cannot be tied to the Nifty Index, for their benchmark could be different!

To generate alpha, an active manager has to follow a unique strategy. If many managers follow the same strategy, how can only some deliver above-average returns? Mutual fund managers will not divulge their alpha strategy; if they do, their strategy will not be unique. In the absence of information about alpha strategy, how should you choose active funds?

Look for the dispersion in returns between the top-performing and the bottom-ranking funds in a style universe. You will typically find the dispersion in fund returns higher for mid-cap/small-cap style than for large-cap style. This means it is better to bet on mid-cap active funds than on large-cap active funds. Why? Dispersion of returns in a style universe suggests market inefficiency. Fund managers can generate sustainable alpha when markets are more inefficient.

Also, alpha is a product of skill and luck. As dispersion of returns between top-performing and lowest-ranking funds reduce, luck will play a larger role in the top-performing managers generating alpha! If skill is the only factor in generating alpha, why does an active fund that performs well over a five-year period struggle to maintain its top-ranking position over a three-year or a one-year period?

If you decide to buy an active fund for your goal-based (core) portfolio, you ought to pick a fund that is likely to generate alpha in the future, based on its past performance. And that may be difficult to choose, as skill and luck are intertwined.

Satellite alpha An index fund contains only market risk (systematic risk) and, therefore, generates only market returns. Logically, an active fund should carry market risk and active risk; the latter represents additional risk that an active manager assumes to generate alpha. You should assume only market risk for your core portfolio and active risk for your satellite portfolio. The satellite portfolio is set up to generate higher returns without being aligned to any of your life goals.

There are skillful managers who can generate alpha. However, even good fund managers can continually generate negative alpha due to bad luck. The truth is that even using statistical models, it is very difficult to differentiate luck and skill while analysing a fund’s alpha. So, you should try your luck with active funds within your satellite portfolio. That way, you can minimise adverse impact on your life goals.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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