You can either diversify your equity investments or position your investments to generate positive alpha, but you cannot possibly do both. In this article, we discuss why true diversification does not allow for alpha generation.
Alpha source
Positive alpha is the excess return that a fund generates over its appropriate benchmark. Suppose a one-year return on a large-cap active fund is 12%. If the fund’s benchmark returns 11% during the same period, the fund’s alpha is one percentage point.
Alpha returns can be generated from sector allocation and security selection. You can determine a sector weight in an index by adding the weight of each stock in the sector. The weight of each stock is the free-float market capitalisation of that stock divided by the free-float market cap of the benchmark index. Suppose the weight of three stocks are 3, 4 and 2% respectively. If these three are the only stocks representing a sector, the sector weight is 9%.
Suppose, a portfolio manager believes this sector will outperform the index in the coming year, but does not have a preference towards any company in the sector. If the portfolio manager assigns 12% to the sector, this weight will be spread across the three stocks in the ratio 3:4:2. If the sector outperforms the index, the fund would have generated positive alpha from sector allocation.
If the portfolio manager has a view that a stock will do better than other stocks in the index, then he/she may assign more weight to that stock, say, 4% instead of its index weight of, say, 2%. That is security selection. A portfolio manager typically takes simultaneously bets on sector allocation and security selection.
Market risk
The outcome on equity investments is uncertain. This uncertainty causes anxiety and leads to regret if the outcome is contrary to expectations. It is to reduce this future regret that we diversify.
The natural process of diversification involves creating a portfolio that is exposed to only market risk; for this risk cannot be diversified. So, a diversified portfolio has two characteristics. One, it ought to carry risk associated with factors that impact the entire market. And two, it ought to have insignificant exposure to factors that can affect individual companies or sectors.
Take two companies, one manufacturing steel and the other, automobile. If increase in steel prices augurs well for the steel company, the argument is that it could have a negative effect on the automobile company as steel is a major input for automobiles. If the portfolio is well-diversified, the impact of the increase in steel prices will be insignificant, as the positive effect of steel price increase on steel stocks ought to be cancelled by the negative effect on stocks of companies that use steel as input.
Practically speaking, a well-diversified portfolio is difficult to construct as it would require holding too many stocks. The Nifty 500 index, representing 97% of the market, can be considered as a diversified portfolio. A fund benchmarked to this index must take bets on selected sectors and individual stocks to generate alpha. So, a fund positioned to generate alpha cannot be diversified.
Conclusion
You can invest in a diversified fund, or you can buy a fund that aims to generate positive alpha. Technically, you cannot hope to achieve both through a single investment. A truly diversified fund cannot generate alpha, as it would have insignificant additional exposure to securities and sectors compared with its benchmark weights. Remember, alpha is generated taking bets on sector allocation and security selection. You should be mindful of this argument when you setup goal-based portfolios. Positive alpha is good for goal-based portfolios, but negative alpha can be more painful. True diversification (broad-based passive funds) could be better.
(The author offers training programmes for individuals to manage their personal investments)
