This blog is the fourth and final article of the four-part series that I am writing on constructing and reviewing equity mutual fund portfolios.
In Part 1: Active vs Passive Funds: Where should you invest?, we discussed the merits and demerits of investing in index funds. In Part 2: How to leverage SEBI Product Categorisation to your advantage?, we focused on actively managed equity funds. SEBI guidelines on product categorisation has ensured that each fund sticks to their basic investment mandate. This information can be used to construct equity fund portfolios that minimise underlying stock overlaps. In Part 3, “Is your portfolio positioned for a differentiated performance than the index?”we discussed what you can expect from your current fund portfolio. Will your investment returns be similar to the broad stock indices or are you positioned for a differentiated performance than the index? In the concluding part of this series, we will evaluate strategies that can help you beat the markets.
So, the obvious question is what is the market? As investors, we need a benchmark that represents the market. Let us start by learning from professional fund managers on selecting an appropriate benchmark and building strategies to beat the same.
How do fund managers make their investment decisions?
It is vital for us to understand the concepts of “Active Share” and “Alpha” to better appreciate the strategies adopted by professional fund managers while making investment decisions.
According to Investopedia, an Active Share is a measure of the percentage of stock holdings in a Fund Manager’s portfolio that differs from the benchmark index. A passive Fund Manager replicates an index and hence the underlying holdings and stock weights in their portfolios are no different than that of the index. The active share of index funds is “zero”. An active fund manager, on the other hand, invests to beat the index. This can be done by investing in different stocks or allocating a different weightage to the stocks in their portfolio as compared to the index. An active Fund Manager investing 100% in stocks that are not a part of the index would have an Active Share of 100. Larger the Active Share, larger is the performance differential!
The bottom line is that if you have to beat the index, you have to invest differently from the index. Active share measures this difference. This could be positive (outperformance) or negative (underperformance). Fund Managers use the term Alpha (Alpha = Fund Performance less benchmark Index Performance) to measure their performance. Higher the alpha, higher is the value they have added to your investments. Active Share is the key driver of alpha.
So, what should be the benchmark to measure your performance?
I believe that as an investor, Beating the market essentially means beating the investment returns of the BSE Sensex or Nifty 50 or Nifty 100 (read large cap indices). So your investment benchmark should be one of the large cap indices.
The large cap indices generally represent over half of the overall market capitalisation and hence if you can outperform these indices, you would have done better than the market! You can only achieve this by having a large active share – this will eventually determine your performance relative to the benchmark indices.
In the next section, let us review the alpha strategies that you can adopt to beat the markets.
Five alpha strategies to beat the markets!
Let me start the discussion by reiterating the importance of adding alpha to your investment portfolio.
Refer Table below. Rs 100,000 invested for 30 years grows to Rs 13 lakhs (assuming an investment return of 9% p.a.), but if you could generate 12% p.a., the same investments would grow to nearly Rs 30 lakhs. You would have added 125% more to your wealth!
A slightly better investment return can make a big difference to you wealth in the long run!
So, what does it take to beat the markets? How do you add alpha to your portfolio?
The answer is simple, you need to have a higher active share. This can be achieved by investing in Equity Funds that have mandates to invest differently from the large cap indices. Let me share with you five different alpha strategies that can help you do that.
- Concentration: Invest in a concentrated portfolio of stocks. A Focused Equity Fund manager does exactly that. They limit the number of stocks to 25 to 30 and if their bets turn out correct, they can potentially beat the markets.
- Differentiated Sector Composition: Nifty has over 30% allocation to financial services. If you create a portfolio that has significant different sectoral allocation than the index, you would have a very different performance. For example, if you own a Pharma Fund or a Technology Fund then the allocation of these funds is zero to financial stocks. Hence your portfolio will perform very differently from the Nifty index. You can create a differentiate sector composition by investing in Sector or Thematic Funds.
- Market Capitalisation: If you invest 100% in mid and small cap funds, the allocation of these funds in large cap stocks will be practically zero. This would lead to a significantly different performance to that of the large cap indices.
- Investing Overseas: If you were to invest in a NASDAQ or S&P 500 fund that invests 100% in international stocks, you would not have any allocation to Indian equities and this would lead to a different performance.
- Owning other asset classes: Invest in an asset class that are different from equities. Cash, Gold, Real Estate and Bonds are good examples of the asset class differentiation. By investing in Hybrid products or other asset classes, you are taking a bet that these asset classes would do better than equities and if you are right, you would again end up beating the markets.
What can go wrong?
There are three big challenges that you will have to address as you invest with the aim of generating higher returns than large cap indices.
First, your investment thesis may not work out. Let me give you an example that you can easily relate to in the current market context. The The BSE Sensex is at an all time high and with a lot of commentators suggesting that the economic situation does not warrant this optimism, you may be tempted to sell all your equity holding and invest in debt funds or any other asset class. If the market continues to grow and does not come back to the current levels, you will end up underperforming relative to the market. Another example here could be that you invested in an index fund that replicates the US NASDAQ index. Your investment thesis here is that the NASDAQ index represents the best of technology companies in the world and hence it should do better than the Indian markets over the coming years. But for some reason this does not work out!
Second, your investment thesis was right but you made the wrong fund choice. From my experience over two decades, all I would say is that there is no sure shot way of identifying the best fund within a category. For example, you invested in small cap funds with the belief that small cap companies will outperform large cap companies in the long run. It may happen that your investment thesis was right but you invested in a small cap fund that did not deliver as per your expectations. This definitely sounds terrible, doesn’t it?
The third one is the most important challenge. Your investment thesis may take some time before it delivers the desired results. Your investment call was right but it so happened that your initial experience was contrary to what you had expected. Let me give you an example of this:
Refer the table above. You invested in small cap funds with the view that they would beat the large cap funds. If you implemented this strategy in 2018, you would be in for a rude surprise. Small caps delivered -18% while large cap delivered +1% return in that year. You waited patiently for the strategy to work out. In 2019, small caps delivered -2% while large caps delivered +10%. You got desperate and moved back to large caps. In 2020, small caps have delivered + 28% as compared to large caps that delivered +14% (2020 YTD as of December 25, 2020). The same numbers for small cap and large cap funds are -3% and +8% respectively (YTD 2020, as of October 19, 2020). This is a grim reminder that market situations can change rapidly.
The point I am trying to make here is that you may be right in your investment thesis, but it may take time to bear the desired fruit. No wonder many investors prefer investing in index funds or large cap funds! They often cannot manage the underperformance that is associated while investing to generate alpha in their portfolio.
So, what strategy should you follow?
The rewards of generating alpha are so high that it is worth trying to implement the five alpha strategies that I have discussed earlier in this article.
If you are starting your journey in equity investing, you can start with a smaller allocation to the alpha strategies. As you gain experience and develop an investment thesis, you can allocate more to the alpha strategies.
In the ultimate analysis, your goals and objectives should dictate your investment strategy. If your goal is to create wealth, an alpha strategy makes a lot of sense. If your goal is to track market performance (read “you only seek market returns”) then, a passive strategy makes sense. And if you want to truly preserve your wealth, international diversification matters the most.
Conclusion
I would like to conclude this series with a simple piece of advice. Alpha matters but it is not easy to generate alpha. You would need the strength of your own convictions to sail through periods when your strategies do not deliver as per expectation. But I must say, the rewards of doing so are worth the effort!
