Active or passive? Why investment grammar is important

Your decision to choose investment products depends on your investment objectives. Are you, for instance, investing to achieve a life goal or are you investing your surplus cash? This is important because you can give up significant liquidity if you are investing surplus cash. Whereas, you need liquidity if you are saving to achieve a life goal.

This week, we focus on your goal-based investments and delve into a related question: what factors should you consider before investing in active funds for your goal-based portfolios?

Alpha trade-off

All of us like more money than less. So, our default choice ought to be active funds. These are mutual funds that strive to beat the benchmark index. The excess return that these funds provide over their appropriate benchmark is referred to as the alpha. Positive alpha is good for us; for excess return translates into more cash flows to achieve our goals.

There is another positive aspect to alpha. Suppose, the benchmark index returns minus 10% in a year and your fund generates minus 7.5%. You save 2.5 percentage points of loss on your investment.

But there is a trade-off. A fund manager has to take active bets to generate alpha. In an attempt to generate positive alpha, the fund could generate negative alpha returns, lower than the benchmark index.

That would lead to lower returns, translating into a shortfall in the amount you want to accumulate to achieve your goal. Can you simply buy a fund that has generated positive alpha in, say, the past five years? That would be a meaningful decision only if a fund that generated positive alpha in the last five years is likely to continue generating alpha in the future. The point is that alpha generation is dependent on two factors viz. skill and luck. The problem is that you cannot differentiate luck from skill.

Choice regret

A good portfolio manager can generate negative alpha because of bad luck whereas a not-so-skilful manager can generate positive alpha because of good luck. So, looking at only the alpha returns for the past five or ten years may not suffice. You have to also analyse the fluctuation in the fund’s alpha over the years. Typically, greater the fluctuation, lower the confidence that the fund will be able to sustain its alpha in the future.

Now, statistical analysis can only reduce the error of picking a wrong fund because luck is a factor in alpha generation. Besides, will you be able to continually engage in rigorous analysis to take decisions?

Also, how many funds will you analyse? For instance, there were 33 large-cap funds as of June according to the Association of Mutual Funds of India. So, you have to apply a rule to narrow your choice to three or four funds before doing any analysis. It is possible that several funds you did not choose could outperform the fund you invested in. Will you shift to one of those funds? What if the fund you shift to underperforms the following year? The more the choices, the more the regret because the ones you do not choose can potentially do better than the ones you did!

Investment decision making can, indeed, be overwhelming. An active fund exposes you to both active risk (negative alpha) and market risk. A passive product such as an exchange-traded fund or an index fund exposes you to only market risk.

So, you have to clearly define your objectives. Which is more important: generating alpha or achieving a life goal? Remember, there are active funds that will generate positive alpha. Do you have the confidence of picking such a fund, and managing your choice regret? If yes, you should invest in active funds. If not, you should settle for a passive product.

(The writer offers training programmes for individuals to manage their personal investments)

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Printable version | Sep 28, 2021 12:01:12 AM |

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