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How Much Alpha Is Good Alpha!!!

In my role as a mutual fund distributor, for equity funds, I have taken to only professing index tracking mutual funds. Various studies across years have shown that most of the active mutual funds do not match up to ROIs given by passively managed, index tracking mutual funds.

However, it is commonplace to hear converse arguments in Indian context – statements like “India is not an index market” or “It is still sometime before index mutual funds beat active mutual funds”. Mostly, these are generic statements, backed up by opinionated data. SP Global does bring out performance scorecard every six months for Indian mutual funds also. A detailed study of this document is very revealing and trashes the argument that “India is still an active fund market”

That said, I feel even SP Global's SPIVA study compares performance of active funds with respective index. To get a real world feel, one should compare it to index funds which even though low on expenses, do have costs. And then, add the quantum of alpha or excess return required over what index funds deliver. A quick google search yields one answer – any alpha is good alpha. Not very convincing, is it? Or maybe it's just me who wants to move beyond the ubiquitous search engine and look for answers elsewhere.

Let’s ditch the percentages for a while and work with absolute values. When I go for growth investing, I am looking at reasonable upside in the value of my capital. Say I want to deploy INR 25 Lacs in some mutual fund for a decade. At one side, I can keep it simple and put my money in index fund, which say gives annualize ROI of 12%. This results in my capital growing upto INR 77,64,621/- at the end of 10 years. The question now arises – upto what value should my capital grow to justify going for an actively managed mutual fund? Will I be happy with INR 78,00,000/-.  Arguably, that’s still an alpha over passive, though miniscule. 

Switching over to percentages again – can we say, at the end of 10 years, I want excess capital growth of at least 25% over that delivered by index funds? Then only I will consider going with active funds worth the effort. Going by this reasoning, closing value of investment in active fund portfolio should be INR 97,05,691/-, about INR 19.42 Lacs more than that delivered by index funds. This level of outperformance requires active funds to consistently deliver 2.5% annualized return over and above index fund returns***. 

Has this number been achieved by active funds in India? My study with publicly available data shows this is not the case, and hence I stick with index funds. I will put up detailed workings over a series of blogs going forward.

To those who may be of the view that 2.5% alpha is too big an ask, they will be well served by looking up a chapter in very old and popular investment book – The Intelligent Investor. Warrant Buffet, in one of the chapter’s of this wonderfully dense investment book states 4% alpha over markets can be considered to be a solid out performance. So, we have a benchmark here and our expectation of 2.5% alpha by active funds is not very over the board!!!

*** Check out detailed workings here.

Disclaimer: As I am associated with mutual fund industry, please bear in mind that I am an interested party in any posts related to mutual funds and securities market. Reader due diligence required in such matters. Also, such posts are not intended to be investment advise as I am not a registered investment advisor. 

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