This divergent trend in the mutual fund universe has led many investors to conclude that their exposure should only be in active funds and that index funds have lost relevance in the current market structure.

This article explores this perception. We believe that active funds will continue to outperform their benchmarks as long as the market is trending up. These funds will likewise under perform when the market turns down. Since investors cannot time the market turns, an optimal strategy would be to shift from active funds to index funds when the personal fear-factor is high and switch back to active funds when the fear-factor fades away.

Active funds generate alpha. Alpha is the excess return generated because of the manager’s skill. Suppose an active fund with a portfolio beta of 1.5 returned 100 per cent last year against a market return of 50 per cent. The fund’s beta-adjusted return will be 75 per cent (50 times 1.5). The difference of 25 percentage points is due to manager selection and is called the portfolio alpha.

Alpha generation has been possible because active managers loaded large-cap stocks such as BHEL and mid-caps such as Unitech well before the uptrend began. These fund managers continually take profits and move into other stocks that are potential alpha generators.

The problem is that portfolio managers cannot consistently beat the market with the same alpha-generators. After sometime, alpha returns will be replicated by other investors and will, therefore, become beta-drivers or market returns.

We, however, do not believe that the total alpha generators in the market will decline as more professional managers exploit mispricing in asset prices. Funds will continue to generate alpha, as portfolio managers plumb new models to uncover hidden values in the market. But alpha generation has its risks.

The primary risk in active management is the underperformance risk. What if the portfolio manager bought Aban Offshore at Rs 1,000 and the stock did not move to Rs 4,500 but instead fell to Rs 500?

The active risk is very high for two reasons. One, funds have large exposure to each stock. If the portfolio manager sells the shares because her security selection was wrong, the fund will suffer high impact cost. Second, when the market turns down, failed alpha-generators typically decline the most.

The active risk in a market downturn is higher than that in an uptrend. A portfolio of 20 stocks will carry at least 4-5 large alpha-generators. The portfolio manager will not, therefore, bother about selling the underperforming stocks as long as the other non-alpha-generating stocks provide market return.

In a downturn, however, the manager will have to necessarily sell such stocks and rebalance the portfolio to contain overall risk.

Often, the failed alpha-generators the manager had in the portfolio will decline the most. And that translates into large losses, forcing active funds to lose more than the market index. So, how should an investor tilt her exposure to mutual funds?

We believe that the discerning investors should move between active funds and index funds when the market turns.

An investor need not use any analytical tools to pick the market turns. We believe that intuition works well in the market, especially when it has to do with fear.

The fear-factor is a function of an investor’s psyche, media exposure and intelligence gathered from market sources. The fear-factor is high when the investor reads and hears about a market decline and strongly believes that such a turn is highly likely.

We suggest that an investor shift at least 30 per cent of the total portfolio to index funds when her fear-factor is high. The balance 30 per cent can remain in the active funds and 40 per cent should be in money market funds.

When the fear-factor fades away, the investor should move back from index funds to active funds.

This is not a tactical asset allocation process. That is, the investor is not encouraged to time the market turns. Neither should the investor engage in such rebalancing process often.

The move from active funds to index funds should happen only once and that too when the fear-factor is high. The move back to active funds should happen when the fear-factor fades away.

We believe that the fear-factor would coincide with what Elliot-wave practitioners call as the fourth-wave structure. The objective is to participate in the uptrend through active funds and to contain price risk in a downturn.

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