The decision on whether to invest in a passive fund or an active fund is not easy. Investing in a passive fund appears behaviourally optimal and investing in an active fund can generate additional returns.
In this article, to help you make a mindful choice between passive and active funds, we discuss how alpha returns could impact your life goals.
More or less
Alpha is the difference in returns between an active fund and its benchmark index. Suppose an active fund generates 14 per cent return against the benchmark return of 13 per cent, the fund is said to have generated a positive alpha of one percentage point.
Consider investing in an active fund from a perspective of a goal-based portfolio. Suppose along with adequate bank deposits, an index fund generating 12.75 per cent can help you accumulate wealth to make a down payment to buy a house.
Then, an active fund generating a 14 per cent return would help you make the down payment and pay for the plush interiors of your dream house.
On the flipside
There is also a flipside to investing in active funds. Portfolio managers must bet on stocks that they believe will outperform other stocks in the benchmark index.
Taking such bets means investing more in (overweighting) some stocks and less (underweighting) in others in relation to the weights of these stocks in the benchmark. If such active bets turn correct, the fund will generate positive alpha.
If such bets go wrong, the fund will generate negative alpha. From the perspective of your goal, negative alpha could mean you fail to accumulate enough money to make the down payment for the house. Of course, you can still buy the house by borrowing more or liquidating investments earmarked for other goals.
Consider the behavioural side of your investment decision; generating positive alpha can make you happy whereas earning negative alpha can lead to pain. The level of pain because of falling short of accumulating the required wealth to achieve a goal can be more than the level of happiness from earning greater returns.
This argument is especially true for high-priority goals such as funding a child’s education. Your decision to invest in the active fund must, therefore, be based on two factors.
One is your confidence in identifying active funds that have greater chances of generating positive alpha during the time horizon for your life goal. And two, the behavioural mindset to understand that pain can dominate (negative alpha) pleasure (positive alpha).
(The author offers a training program for individuals to manage their personal investments)