If you have been investing in active mutual funds, you will be familiar with the term “alpha”. This refers to the excess returns that a portfolio generates over its appropriate benchmark. For instance, if a large-cap active equity fund generates an annual return of 15 per cent and the NSE 50 Index generates 14 per cent during the same period, the fund’s alpha is one percentage point. In this article, we briefly discuss two important characteristics of alpha.

Have you ever wondered how your school mate, who was just an average performer in the class, became so wealthy and successful? The truth is that all skilful individuals are not successful. And all successful individuals are not skilful. Suffice it to say that luck plays an important role in an individual’s success.

The same applies to the investment world! That means a not-so-skilful manager can generate a positive alpha because of good luck and a skilful manager can generate negative alpha because of bad luck. And it not easy for you as a mutual fund investor to differentiate luck and skill!

So, you would possibly reject a skilful manager because she generated a negative alpha in the recent past and invest in a lucky manager who generated a positive alpha. Small wonder if your investment performs poorly after a while.

A zero-sum game

Another important characteristic is that alpha is a zero-sum game. This means the sum of all positive alphas in the market must equal the sum of all negative alphas. Why? Assume that the entire market is made up of only 100 managers. If all of these managers were managing passive portfolios (large-cap index fund managers), they would simply deliver the index returns. But suppose one manager decides to turn active. Can she generate alpha? The answer is no! Why?

To generate alpha, the active manager has to overweight/underweight stocks in her portfolio relative to the NSE 50 Index. Suppose she decides to have 12 per cent weight in HDFC Bank instead of the benchmark weight of, say, 10 per cent. But she can get additional shares of HDFC Bank only if one or more of the remaining 99 managers decide to reduce their weight in HDFC Bank (as passive managers, they all hold 10 per cent weight).

Suppose two of the 99 managers decide to reduce their weights in the stock. Now, assume HDFC Bank generates higher returns than the remaining 49 stocks in the NSE 50 Index. The manager who went overweight on HDFC Bank will generate a positive alpha whereas the two managers who went underweight on the stock will generate an equivalent amount of negative alpha. The other managers will generate index returns.

The above discussion shows that alpha is not easy to generate and that picking the “right” active fund is even more difficult. Yet, the reward for investing in active funds (earning positive alpha) is so attractive that many individuals buy such funds.

The author is the founder of Navera Consulting

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