Any performance can be measured only against a standard or reference. The benchmark for a team batting second in a cricket match is the score achieved by the team that batted first. Only if it scores more, the team batting second is said to have performed well.
Similarly, for a student, the minimum pass mark or grade is the benchmark to measure his performance. Alternately, his performance can also be evaluated with reference to that of his classmates.
It hence becomes evident that performance cannot be evaluated in a vacuum and has to be done with reference to some external standard or expectation. This standard is what is referred to as a benchmark in investment. Any investment product has to match or better the performance of its identified benchmark to justify the fees and charges that it collects from the investors.
The Main Benchmark Indices in Investment Industry
Indian equity indices like S&P BSE Sensex, NSE Nifty, BSE 200, BSE midcap index, BSE small-cap index, Nifty 500 are common among equity mutual funds. These indices are compiled and maintained by the respective stock exchange-owned entities. Debt funds are usually benchmarked to the appropriate CRISIL index.
Reason for Different Benchmarks for Different Mutual Funds
Mutual fund schemes invest in various assets like debt, equity, gold, etc. It is, therefore, pertinent that there cannot be one common benchmark for all investment products. An equity fund may have the S&P BSE Sensex as its benchmark, whereas, a debt fund may have a composite bond fund index as its benchmark. Put simply, apples and oranges cannot be compared. We need to compare one apple with another apple, not with orange.
Having an inappropriate benchmark leads to poor comparison. For example, a large-cap mutual fund scheme needs to be benchmarked with a large-cap index like the Sensex or the Nifty index. If it is benchmarked against a midcap index, the comparison is going to yield no useful information and any action initiated on the basis of such a comparison will lead to poor investment results.
What is Alpha Approach in Investment Industry?
Returns generated by an equity mutual fund could broadly be divided into two components. The first part of the return is due to the market movement. When the market goes up, the fund portfolio too increases in value and hence, generates returns for the investors. In other words, the rising tide lifts all boats, including yours.
There is no particular skill or effort required to achieve this market-generated return except being invested. This is often referred to as the Beta of a portfolio. Passively managed schemes like Index funds and Exchange Traded Funds (ETFs) aim to achieve just this and hence, offer a lower cost of investment.
The second component of a scheme’s returns is due to the fund manager’s skill and the contribution of the research team of the fund house. By taking smart sectoral and stock selection decisions apart from timely investment and disinvestment decisions, the fund manager and his team aim to generate better returns than that of the underlying market or the scheme’s benchmark.
The effectiveness of this endeavor depends on the fund manager’s skills and the fund house’s investment management process. This second component of the return is what is generally termed as Alpha in mutual fund parlance.
It is nothing but the excess return generated by the scheme over and above what is given by the market. This is a measure of the value addition provided by the fund manager’s skills, the contribution of his research team, and the fund house’s investment philosophy.
How Alpha Approach Helps Investors?
It, therefore, becomes evident that there is no Alpha involved with passively managed funds. Alpha is relevant only to actively managed funds. This effort by the active fund manager to outsmart the market inadvertently adds a risk element to actively managed funds. While the actions may generate positive Alpha, there is also the risk that the investment calls go wrong and create a counter-productive result of a loss for the investors.
However, as evident from the last section that passively-managed funds just aim to earn the market-generated returns for their investors. Whereas, actively-managed funds aim to generate Alpha with astute stock selection and other market-related skills to offer a superior investment result to their investors.
Can Alpha Approach Outperform Benchmarks?
Actively-managed funds are expected to outperform the respective benchmark market index. Active funds, therefore, charge a fund management fee to offer you the extra return potential due to their expertise. It, therefore, becomes pertinent for you to check if the scheme that you have invested in, or are considering, is offering the extra returns over the market, for which it is charging you the fund management fee.
|Fund Name||Alpha (%)||Beta (%)||Sharp (%)||Returns|
|3 Years||5 Years|
|Kotak Bluechip Fund||1.82||0.95||0.77||19.54%||17.55%|
|Axis Bluechip Fund||4.21||0.77||0.89||19.57%||20.06%|
|Benchmark – S&P BSE 100 TRI||18.32%||17.51%|
|Fund Name||Alpha (%)||Beta (%)||Sharp (%)||Returns|
|3 Years||5 Years|
|UTI Flexi Cap Fund||6.38||0.94||1.01||24.99%||20.99%|
|Parag Parikh Flexi Cap Fund||11.92||0.72||1.31||30.39%||23.28%|
|PGIM India Flexi Cap Fund||7.38||0.99||1.03||29.29%||21.87%|
|Benchmark – S&P BSE 500 TRI||19.76%||18.03%|
As actively managed funds come with an extra element of risk over passive funds, the scheme should generate sufficient Alpha over a period of 5 years to compensate for not only the extra risk taken but also the extra expense incurred. But for measuring performance an investor should consider a longer time period 3-5 yrs. If an actively managed fund is struggling to generate Alpha over a short period like 1-2 yrs it’s not called underperformance they will require 1cycle of bull and bear run to beat the benchmark and generate alpha.
If over a period of 5 years if a fund has not generated alpha then there is no justification for the fund management fee that it charges and the extra risk that it exposes you to. You may as well invest in a passive fund with concomitant savings on fund management expenses (which eat into the return generated by the portfolio) while enjoying a lower risk element too.
The Last Words
Diversifying your portfolio and using established approaches like value investing is among the numerous alternatives an investor has to create money, are the ones that work to outperform the market, each of which takes time to build wealth. Patience and the ability to avoid panic selling when the market takes a negative swing are essential components of these approaches.
If you are looking for a reliable Investment Manager who can help you compare the alpha generated by your portfolio, get in touch with us. Using our alpha approach, we help our investors compare their returns and restructure their portfolios to generate more alpha than others.
The article is written by Manju Mastakar and who has over two decades of experience in managing investments