Are Your Equity Mutual Funds Generating Alpha Returns?

October 16, 2023 Mutual Fund

Diversified equity mutual funds have proven their mettle over the past year since the markets have been agitated by constant volatility.

The equity-oriented schemes have efficiently managed the ups and downs caused by variables, including increased interest rates, rupee depreciation, sticky inflation rate, sluggish global demand, higher valuations, and geopolitical concerns. According to historical data, most equity-oriented mutual funds have produced significant returns compared to their benchmarks despite the high volatility.

Especially in the realm of actively managed equity mutual funds, the schemes generating substantial alpha returns are considered to provide investors with the most value.

What are Alpha returns in mutual funds?

Alpha is a term used in investing to describe an investment strategy’s ability to outperform the market. It calculates a fund’s excess returns over projected returns while also considering fund management expenses.

Diversification is meant to reduce unsystematic risk, while active portfolio managers aim to produce alpha in diverse portfolios. Since alpha measures a portfolio’s performance in relation to a benchmark, it’s sometimes thought of as a measure of the value a portfolio manager adds to or deducts from a fund’s return.

In this article, we discuss the investment strategies investors can follow to generate alpha from equity mutual funds. Let us analyse the performance of actively managed pure equity funds over the long term to see who’s leading the pack.

Table: Performance of various mutual fund categories across the timeframes

*Performance as of October 13, 2023. Category average returns are considered for each category. Returns are Point to Point and in %, calculated using the Direct Plan-Growth option.
Past performance is not an indicator of future returns.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF, data collated by PersonalFN Research) 

According to the SPIVA Report as of October 10, 2023 – In the first half of 2023, performance among Indian active managers varied across categories. The majority of Indian Equity Large-Cap mutual funds failed to beat their underlying benchmark indices, with 58% of actively managed funds underperforming the S&P BSE 100.

However, when assessed over the last one year, certain sub-categories of actively managed equity mutual funds, such as Mid cap Funds, Small cap Funds, Value Funds, and Contra Funds, have performed well as compared to the broad benchmark indices, yielding value for the investor.

In the past six months, the Mid Cap Fund Category generated average returns of 25.71%, while the Small Cap Mutual Fund category generated average returns of 29.46%, driven by a sustained broad-based rally in the equity market. The two categories outperformed the Large Cap Mutual Fund category average of 14.19%.

Notably, the performance of the S&P BSE 400 MidSmallCap Index stood out in particular, as it delivered twice the total return of the S&P BSE 200 and outperformed the S&P BSE 100 by over 5%.

Graph: Performance of Equity Indices for 2023

*Performance as of October 13, 2023. Past performance is not an indicator of future returns.
Mutual Fund investments are subject to market risks. Read all scheme-related documents carefully.
(Source: ACE MF, data collated by PersonalFN Research) 

Market analysts observe that mid and small caps remain appealing when compared to historical trends. Specifically, in the current environment, small caps have seemed to be even more appealing than midcaps.

Buoyed by the recent rally, investors poured money into these two soaring categories. Given the overall market consolidation, there are differing views on whether this is the best environment for investing in high-risk categories. Do note although they have the potential to generate alpha returns, mid and Small cap funds are highly risky and volatile in nature.

ELSS mutual funds, on the other hand, had a strong start to the year, underperforming the S&P BSE 200 by just 18%, according to the SPIVA analysis. Over a five-year timeframe, Indian Equity Mid and Small cap funds performed by far the best out of all the categories featured in the SPIVA India Scorecard.

The Indian equities market started 2023 on an upswing, with indices across the capitalisation spectrum posting respectable gains over the first half of the year. However, the current rally is particularly noteworthy for its strength and breadth despite concerns about inflation and macroeconomic uncertainties.

[Read: Market at All-time High: Is This a Good Time to Invest in Mid Cap and Small Cap Mutual Funds?]

In this environment of increasing market breadth, where it’s all about bottom-up stock picking, fund managers may find it easier to pick potential winners to generate alpha, especially in the mid and small cap space.

Given that, depending on the returns produced by the managers of active equities mutual funds, betting on alpha returns can either have a positive or negative influence on the investor. Additionally, different market cycles also have an influence on the alpha returns of an investment across different asset classes.

Don’t be dismayed by the risk of volatility in the equity market. Here are the investment strategies you can follow at a market high and to generate alpha from equity mutual funds:

1. Avoid chasing top-performers

The recent noteworthy performance of the equity mutual fund categories like Mid cap funds, Small cap funds, Value and Contra funds has gained investors traction. Many of you could be tempted to invest in these top-performing schemes or sub-categories in the hopes of earning substantial profits.

However, it is unlikely that a particular mutual fund category or scheme will continue to generate stellar returns year after year. Instead, a preferable strategy would be to choose a scheme with a consistent long-term track record when compared to its category peers and the benchmark rather than basing your decision on recent past success.

[Read: 5 Best Mutual Fund Types for Long-Term Investment Success]

Though there is no harm in examining a fund’s historical performance to assess its potential return, it should not serve as the sole factor considered to make an investment decision. Before investing, you must take into account additional qualitative and quantitative aspects of the scheme.

2. Make a prudent investment choice

Investors now find it challenging to choose high-growth investment opportunities due to the mutual fund industry’s recent wave of new fund offerings. Instead of piling on too many NFOs, stick to a goal-based investment strategy.

Equity mutual funds can help you generate market-beating returns over the long term and maximise your wealth. However, not all mutual funds have the capacity to provide investors with significant alpha. Given this, it’s crucial to pick your mutual funds for your portfolio carefully. The fund must take a degree of risk that is fair for its investment style and strategy in order to reward investors.

Regardless of whether it is a Large cap Fund, Large & Mid Cap Fund, or any other sub-category of equity scheme, the performance of an active equity mutual fund scheme cannot be judged by looking at short-term returns.

An actively managed equity mutual fund scheme’s performance over a longer time period, such as 3 years, 5 years, 7 years, or more, provides a greater idea of how it performs over different market cycles or stages.

Additionally, the likelihood of generating alpha or outperforming the benchmark index is higher if you use active equities mutual fund schemes with strong stock selection methodologies. However, passively managed funds only attempt to match the benchmark index performance and not beat it.

3. Check for the portfolio characteristics

When choosing a scheme, you should consider the portfolio characteristics of the scheme in addition to risk-reward factors to determine its capacity to produce reliable returns. Verify the scheme’s stock and sector diversification, the quality of the securities held in the portfolio, and the portfolio turnover rate.

The skill and competence of the fund management to make the right decision at the appropriate moment and reward investors regardless of market volatility determines a fund’s capacity to produce alpha. Therefore, it makes sense to look at the qualifications and experience of the fund manager as well as the track record of the schemes they manage.

4. Time in the market beats timing the market

Equities market swings may test your patience, and you could be tempted to make some changes to your portfolio. Many investors are under the impression that alpha returns only occur during periods of significant market volatility, and they focus on timing the market.

[Read: How a Sound Investment Strategy Can Help You Mitigate the Impact of Market Volatility]

However, responding to every market blip might have an influence on your returns and make it harder for you to reach your financial objectives. There is no need to adjust your portfolio based on market conditions if your asset allocation strategy is in place. Focus on your time in the market to produce substantial returns rather than trying to time the market.

One must focus on one’s goals by building a suitable portfolio, based on your asset allocation, that can stay strong on both upside and downside market conditions.

5. Don’t let your emotions cloud your decisions

Equity market and volatility often go hand in hand. Volatility and the equity market frequently go hand in hand. During volatile market conditions, many investors panic-sell their mutual funds, which also diminishes their ability to generate alpha returns.

[Read: How Fear And Greed Can Lead to Wrong Investment Decisions]

One must avoid falling prey to behavioural biases in investment decision-making, loss aversion, herd mentality, anchoring bias, etc., which can prevent investors from making sound decisions.

However, volatility is an opportunity for long-term investors rather than a cause of concern. If the market declines due to the volatility, you will have the opportunity to increase your mutual fund investment via SIP at a cheaper cost. And when the market recovers again, you will be rewarded with healthy gains.

To conclude…

After experiencing sluggish growth from 2015 to 2020, India is currently on a cyclical upturn. Only time will tell how long the current rally will last, but it is evident that it is more sustainable than previous ones, given the solid corporate earnings and economic fundamentals, foreign capital inflows, rising exports, and rising valuations.

[Read: The 4 Key Market Trends that Could Drive Mutual Fund Growth]

However, investors should be aware of the risks, such as inflation trajectory and global interest rate environment, which could weigh on the market in the future. Market valuations have risen above historical averages, making them costly.

One should be prudent while investing in high risk segments such as mid and small caps, which have experienced significant growth. Therefore, it makes sense to invest in a portfolio that is well-diversified across market caps, industries, and asset classes. After determining your financial objectives, risk tolerance, and investment horizon, choose worthy mutual fund categories.

This article first appeared on PersonalFN here