In earlier columns, we discussed the risks associated with active funds. With an understanding of these risks, if you decide to invest in an active fund for your goal-based portfolio, how should you set up your investment process? In this article, we discuss why the investment process you set up for active funds should be different from the one you set up for ETFs or index funds.
Active versus passive
An active fund is expected to provide higher returns than its benchmark index. This excess return above the benchmark is called alpha. To generate alpha, an active fund manager must overweight stocks that are expected to do well and underweight stocks that may do poorly relative to the benchmark index. This results in active risk.
An active fund, therefore, carries two risks — active risk and market risk. Active risk could lead to the fund underperforming its benchmark index and generating negative alpha. For instance, a fund could generate 10% returns against its benchmark return of 12% (two percentage points negative alpha). Market risk could lead to the fund generating negative (total) returns. For instance, the fund could generate minus 10% return. In contrast, a passive fund (an ETF or index fund) is exposed to only a market risk.
Now, market risk is unavoidable when you invest in equity funds. But because it is a higher expected returns generating asset, investing in equity is important if you want to balance your current lifestyle with savings. But what about active risk? You can control active risk based on your choice of an active fund. That is why your investment process for an active fund should be different from that of a passive fund.
The investment process is simple for buying passive funds. You must set up a systematic investment plan (SIP) that matches with the time horizon for a life goal. So, if the time horizon for a life goal is eight years, then the SIP (both for equity funds and bank deposits) must be set up for eight years.
But if you choose active funds, the SIP must be set up for one year at a time. Why? The more consistent an active fund is in generating alpha, the lower the active risk. But alpha is a function of both luck and skill. And it is very difficult to differentiate the two.
That means a fund can generate negative alpha after you buy the fund even if it had generated positive alpha in the past. So, you must evaluate the performance of an active fund every year. If you are satisfied with the fund’s returns, you must renew the SIP for another year. Otherwise, you should analyse and choose another active fund.
Now, switching to another active fund can expose you to future regret.
How? Suppose you have currently invested in fund A. Unhappy with its performance, you switch to fund B. What if fund A subsequently performs well and fund B underperforms? If you want to avoid this future regret, you should switch to a passive fund.
Conclusion
Active funds can generate higher returns than their benchmark index when the market is moving up and lower losses than the benchmark when the market is declining. But there is a trade-off — selecting such funds is not easy. You must, therefore, set up an SIP for a block of 12 months to continually evaluate the fund. Therefore, each year of the time horizon for your life goal becomes a decision point.
Such decision points are important for optimal decision. If you switch active funds in three out of five years, it is a telling signal that such funds are not appropriate for you. You should consider switching to a passive fund; for, passive funds benchmarked to the same index will have similar returns and do not require decision points.
(The author offers training programmes for individuals to manage their personal investments)
