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, contribution of his research team and the fund house’s investment philosophy.
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 loss for the investors.
Role of Alpha in fund selection
As evident, passively-managed funds just aim to earn the market-generated returns for their investors. But 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. In other words, 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.
As actively managed funds come with an extra element of risk over passive funds, the scheme should generate sufficient Alpha to compensate for not only the extra risk taken, but also the extra expense incurred. If an actively managed fund is struggling to generate Alpha, 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.