As investors, we want to earn above-average returns. In the context of mutual fund investments, above-average return means earning greater than a fund’s benchmark return. This excess return is referred to as alpha. Active funds strive to generate positive alpha. Small wonder that investors typically prefer active over passive funds. Here, we discuss the arithmetic of alpha returns.
Zero-sum game?
Market, here, refers to the style benchmark of a fund. So, if you invest in a large-cap style fund, market in relation to the fund refers to all large-cap stocks. Likewise, if you were to invest in a mid-cap fund, market refers to all mid-cap stocks.
Now, consider the NSE 100 index, the large-cap style benchmark. The average return in relation to large-cap stocks would be the NSE 100 Index. So, we can state active large-cap funds that generate positive alpha earn above-average returns. But that means some other active large-cap funds must generate below-average returns. How else can the average returns of all these funds be equal to the NSE 100 Index? In other words, alpha must be a zero-sum game.
That is, the sum of positive alpha returns must equal the sum of negative-alpha returns.
Note, there many other funds like diversified and solution-oriented funds that will invest in large-cap stocks. Also, mid-cap funds may invest in large-cap stocks. Therefore, proving that alpha is a zero-sum game is easier said than done.
Nevertheless, the above argument has some implication on your investment decision. If alpha were a zero-sum game, some portfolio managers will win, and some others will have to lose. And, if portfolio managers are skillful, it is highly unlikely the same portfolio managers will always win while some others will always lose. In other words, portfolio managers may be skillful, yet a fund’s annual return can swing between positive and negative alpha between one year and the next.
Conclusion
Given the market behaviour in recent years, portfolio managers must continually move from one sector to another (sector rotation) to consistently generate positive alpha. But more the active decisions (active bets), greater the active risk (likelihood of negative alpha).
Then, there is the alpha fade rate — the rate at which an alpha strategy fades (no longer generates alpha) is faster than the rate at which newer strategies can be developed. You must be mindful of these factors when you invest in active funds.
(The author offers training programmes for individuals to manage their personal investments)