Money Matters. Beating the benchmark is not good enough

Do you analyse fact sheets to decide on your mutual fund investments? If so, you would have typically faced a problem because evaluating a fund to check if it can sustain its alpha is not easy. Alpha is the excess return that an active fund generates over its appropriate benchmark index. In this article, we discuss some issues concerning alpha based on the information disclosed in fund fact sheets.

You cannot simply take the difference between the fund’s returns and benchmark returns as the alpha! Why? Typically, a fund is not true to its benchmark. That is, a fund may follow a large-cap style and have the CNX Nifty Index as its benchmark, but would have several mid-cap stocks in its portfolio. So comparing the fund with the CNX Nifty Index may not be meaningful. Why?

As an investor, you have two choices − invest in an index fund, or buy an active fund with the same benchmark. You should buy an active fund only if you are confident that the fund manager will generate alpha in the future. But if the fund manager deviates from the benchmark portfolio composition, how would you know if your decision to buy an active fund was justified?

Now, you may argue that it is enough if the portfolio generates higher returns than, say, the CNX Nifty Index. Note that having mid-cap stocks in the portfolio changes the risk characteristics of the fund relative to the CNX Nifty Index. What if the fund manager picks mid-cap stocks that substantially underperform the next year? Or what if the fund manager decides to instead buy small-cap stocks?

ICICI Prudential Mid-cap Fund, for instance, has the CNX Mid-Cap Index as its benchmark, but carried about 12 per cent of its portfolio in large-cap stocks according to the information disclosed in its fact sheet for August. The question is: has the fund consistently deviated from its benchmark? You can check the fund’s r-squared to evaluate how closely the fund tracks its benchmark; the closer the r-squared is to one, the stronger the relationship the fund has with its benchmark. Of course, the closer the r-squared is to one, the more the fund will behave like an index fund! But we will save this discussion for a later date. Now, you may be tempted to use a broad-cap index such as the CNX 500 Index to overcome the above issue. You should not! Why? If you use the CNX 500 Index as the fund’s benchmark, you are implying that the fund does not have an investment style. This is because the CNX 500 Index, being a broad-cap index, does not have a style bias.

Alpha is, indeed, the difference between portfolio returns and benchmark returns. However, you need to ensure that the benchmark is appropriate before you measure the fund’s alpha. After all, alpha is the excess returns over the benchmark. So, what use is the alpha measure if the benchmark is not appropriate?

How should you test the validity of a fund’s benchmark? They are several ways to do so. One simple rule is to check previous fact sheets to see if the fund’s beta has been consistently below one or above one. The logic is as follows: the fund manager will typically have high beta stocks in the portfolio if he/she expects the market to move up. Likewise, the fund manager will have low beta stocks in the portfolio if he/she expects the market to decline. So unless the market is in a prolonged uptrend or downtrend, you are unlikely to see the fund’s beta consistently above or below one, as the market is sometimes up and sometimes down. You should be, hence, wary if the fund’s beta is consistently below or above one as this might be because its chosen benchmark is not appropriate.

The writer is the founder of Navera Consulting

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