Should investors bank upon alpha returns of active mutual funds to meet their financial goals? We answer

Active investing is riskier form of investing than passive, whereas the latter is more secure but wealth generation happens at a slower pace

Vimal Chander Joshi, MintGenie Team
First Published21 May 2023, 10:44 AM IST
Alpha returns is pursued by the investors who have a high-risk appetite
Alpha returns is pursued by the investors who have a high-risk appetite

Investors tend to face a dilemma of choosing between active and passive mutual funds while they pursue their financial goals. The passive mutual funds offer returns that are — more or less — closer to those of index mutual funds.

Active fund schemes, on the other hand, give a scope to deliver alpha. For the unversed, alpha refers to the excess return above a benchmark for an investment. 

For instance, when a mutual fund delivers 12 percent return, while the benchmark index (BSE Sensex or Nifty50) gave 10 percent return during the same period — the excess 2 percent is alpha for that scheme.

Should you rely on alpha?

There is no denying the fact that active investing – while delivering alpha — is riskier than passive investing, which is a far more secure form of investing.

So, can investors rely on passive investing, or should they choose active over passive funds while they pursue their financial goals?

Here we try to demystify this mystery:

Some financial advisors strongly believe in the potency of active funds over their passive counterparts.

“Most index funds have either IT or banking stocks in the portfolio. But the real activity happens outside these two categories. So, if you want to take part in the economy, then one should invest in active funds also,” says a Chennai-based registered investment advisor on the condition of anonymity.

To rationalise her argument, she further says, “If you compare Sensex returns and GDP growth. There is a huge difference. While India’s GDP continues to grow, the same may not be true for financial markets year after year.”

So, if someone wants to invest for a long term, say five years, s/he should invest in active funds in order to earn alpha.

“We did an analysis of one of our clients, and his active fund allocation gave three-and-a-half percent alpha over the returns from passive funds,” she says.

Category                  5-year-returns (%)Top performer (%)
Large cap                                 11.2517.46
Contra                                        13.2016.83
Small                                            14.3525.70

(Source: MorningStar, returns as on May 16, 2023)

As we can see in the table above, large cap funds (closer to index funds) have given an average CAGR (compound annual growth rate) returns of 11.25 percent in the past five years, while the active funds falling in the categories of contra and small cap funds have given higher returns i.e., 13.20 percent and 14.35 percent, respectively during the same period.

Another argument that she gives is that index funds (e.g., Nifty50) include only top 50 stocks that have now grown too big, and their returns are now moderate and steady.

But while they were delivering exceptional returns, they were the part of any broader index. “It’s only after a stock reaches a certain point that it is added to the index fund,” she says.

There are some who believe that investors need an interplay of both active and passive funds. While giving an analogy of cricket, one expert says that a match can not be won only by good batsmen, and one also needs good bowlers also.

Akshar Shah, founder, Fixed, investment technology platform, says, “Investors should use the best from all asset classes, diversify and align it to their goals. Alpha returns from equity helps them create wealth for long term goals and fixed income helps them protect and shield their short-term goals against market volatility. It is like you cannot win a cricket match with just good batsmen, you need both good batsmen and good bowlers.”

Some experts, however, caution the investors against assuming that all active funds, invariably, would give alpha.

“Not all active funds give alpha over the passive index funds. A lot of active funds also provide alpha due to time dependent tactical calls. Exiting them at the right time is essential to derive that alpha,” says Renu Maheshwari, a Sebi-registered investment advisor and co-founder of Finscholarz Wealth Managers.

Some also opine that index funds are meant for new investors whereas active funds can be added to the portfolio at a later stage.

"For a new investor, having exposure to a low-cost index fund or a hybrid fund makes sense for starting. Once they know the know hows of the market and build a corpus, they can construct their portfolio around them by adding more actively managed funds," says Nitin Rao, Head Products & Proposition, Epsilon Money Mart.

"Both the approaches have their own pros & cons, therefore, it makes perfect sense to have a mixture of both by trying to strike a perfect balance between the two," summarises Mr Rao.

 

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First Published:21 May 2023, 10:44 AM IST
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