Why Bet On High Alpha Funds In This Gloomy Market
Aug 07, 2019

Author: Vivek Chaurasia

(Image source: freepik.com; Photo Credits: creativeart )

Equity markets are unpredictable. From experience, we know it is difficult to predict the direction of equity markets in the short term. Still we do have a sense where the markets will head in the long run.

While everyone is talking about gloomy markets, it has been a nightmare for investors who are anxious about their gains and capital eroding.

But what many of us probably overlook is the confidence of some astute investors who consider these conditions as a great buying opportunity, to commit some of their long term capital.

"Be fearful when others are greedy. Be greedy when others are fearful."

~ Mr Warren Buffett

Although most of us have read or heard about this famous quote by ace investor Mr Warren Buffett, the majority of us fail to follow this religiously. Instead our emotions force us to do the opposite and sell or stop investing in depressing conditions, when actually that would be an optimum time to add some high quality names to the portfolio.

Also there is another category of investors who sit on the sidelines waiting for the right entry point and capture new lows. However, the irony is their wait never ends and they miss out on the opportunity. Many of them missed out on it in 2009, and they may miss it again.

Are the valuations favourable?

In the budget presented by the Finance Minister Ms. Nirmala Sitharaman, on 5th July, the government proposed raising surcharge on super-rich, which increased the tax burden on Foreign Portfolio Investors (FPIs). The exit of FPI, hit by the budget proposal to levy higher surcharge on income tax, resulted in a blood bath in Indian equity markets. Moreover, deteriorating macros, poor auto sales numbers and US China trade war have further added to the woes.

Graph: Are the valuations favourable?

Are the valuations favourable
(Source: nseindia.com)

In terms of valuations, the P/E of the Nifty 50 index is hovering at around 27x mark while that of Nifty MidCap 100 index is now trending below 30x (as per the historical PE data published on nseindia.com). Clearly, the valuation in the large cap segment is still in an overvalued zone, whereas midcaps are below their average levels, indicating a good entry point.

As calculated on 5th August 2019, the large cap Nifty-50 index has corrected nearly 10% from its all-time high of 12,088 (seen in the first week of June 2019), and is down over -4% in the last one year. On the other hand there is a sharp deviation in the levels of midcaps and small caps that had witnessed a dream rally in CY 2016-2017. The S&P BSE Midcap is down nearly -27%, while the S&P BSE Small cap index has crashed nearly -39%, from their all-time high seen in January 2018.

Even though the large caps are trading at a higher level, the mid and small caps are available at a deep discount from their all-time highs. I believe, for investors who can bear the short-term pain and volatility, it may be an opportunity to gradually add up equity exposure. If not, then better wait till the market sentiments improve.

Where is the Alpha? Are mutual funds slowly losing the faith of investors?

Most of the actively managed diversified equity funds primarily aim to generate alpha by "not mirroring the index". However, not all funds are successful. In fact, in the last few years generating alpha has been a real challenge for most of the active fund managers.

In one of the recent studies, I found that almost 6 out of 10 equity funds have underperformed their benchmark index in the last 3 years and 7 of 10 funds have simultaneously underperformed the broader S&P BSE 200 - TRI index. Notably, the alpha for the rest has shrunk, thus breeding doubt in the capability of actively managed funds.

With their funds having underperformed, some investors have even shunned their holdings in actively managed funds and moved towards low cost index funds in order to satisfy their investments with returns in line with the markets and forgo alpha generation.

I have noticed many investors have a vague understanding of what alpha really is and compare it with getting high and consistent market beating returns, which in the true sense is actually difficult. Though it's not wrong expecting alpha returns on investments, many don't actually know if they are getting any.

The true essence of alpha is to generate 'extra return without taking extra risk'. When a fund generates alpha, it means it gets more returns for the investors at a reasonable level of risk, much suitable for its investment style and strategy.

An alpha very much depends on the expertise and ability of the fund manager in taking the right call at the right time and reward investors, irrespective of the market movement.

Table: Are actively managed funds still struggling?

Category   2019 (YTD) 2018 2017 2016 2015 2014
Large Cap Fund Top Gainer 6.2 8.1 52.7 18.7 9.0 75.6
Top Loser -10.8 -16.3 21.9 -4.4 -5.5 27.7
Category Average -0.2 -1.8 33.2 5.0 1.6 42.4
NIFTY 50 - TRI 1.0 4.6 30.3 4.4 -3.0 32.9
Large & Mid Cap Top Gainer 6.8 1.7 54.1 14.4 18.8 97.6
Top Loser -7.6 -16.4 29.5 0.9 -4.8 27.8
Category Average -3.1 -6.4 40.3 7.7 5.6 54.1
S&P BSE 500 - TRI -2.9 -1.8 37.6 5.2 0.4 38.9
Multi Cap Fund Top Gainer 5.3 8.8 49.8 16.2 15.7 74.4
Top Loser -11.9 -16.8 26.9 -5.9 -7.3 38.8
Category Average -2.3 -4.8 37.8 4.4 3.4 53.5
S&P BSE 500 - TRI -2.9 -1.8 37.6 5.2 0.4 38.9
Mid Cap Fund Top Gainer -2.7 4.6 53.7 16.3 17.9 91.8
Top Loser -12.4 -17.0 30.9 -3.9 -15.1 27.1
Category Average -7.5 -10.9 43.9 5.8 8.3 70.4
S&P BSE Mid-Cap - TRI -12.7 -12.5 49.9 9.3 8.7 56.9
Small cap Fund Top Gainer 1.4 -6.7 80.4 13.6 22.3 112.8
Top Loser -26.7 -28.6 39.8 -2.2 1.0 51.5
Category Average -10.7 -17.8 55.0 6.5 11.5 85.3
S&P BSE Small-Cap - TRI -16.0 -22.9 60.8 2.7 7.7 71.1
Focused Fund Top Gainer 10.9 2.9 56.8 13.1 17.9 83.0
Top Loser -6.6 -13.7 24.9 0.8 -4.1 32.9
Category Average -0.4 -5.0 38.4 6.1 3.4 52.4
NIFTY 50 - TRI 1.0 4.6 30.3 4.4 -3.0 32.9
Value / Contra / Dividend Yield Funds Top Gainer -0.8 3.8 63.1 16.9 13.8 100.5
Top Loser -13.3 -22.6 21.7 -0.8 -5.2 39.0
Category Average -5.6 -7.7 40.4 7.6 1.6 56.3
S&P BSE 200 - TRI -1.8 0.8 35.0 5.4 -0.2 37.4
Returns in (%) Absolute. YTD as on August 05, 2019
(Source: ACE MF, PersonalFN Research)

As we can see in the table above, the performance of actively managed mutual funds across categories was not very great in 2018. Barring mid and small caps, all the other category of funds significantly underperformed their comparative market index. Although there were some winners too across categories, the overall performance was clearly dominated by losers. Generating alpha was simply out of question for many.

Nonetheless in 2019, actively managed funds seem to be in a better position, with a drop in the margin of underperformance. Although, not all funds are winners, the number of underperformers has certainly come down, giving a new ray of hope for investors.

In conditions where funds are struggling to keep pace with the benchmark, finding the real long term winners is imperative, however, rather difficult. Nevertheless, there are quite a few well managed funds that have the ability to generate alpha for investors, at a reasonable risk. These may be an optimum choice to gradually add up your equity exposure especially in conditions like these.

While I cannot say if any further downside remains, we can't ignore the fact that markets have the ability to bounce back unexpectedly. Staying on the sidelines waiting to time your entry point may not be a prudent strategy. Instead stagger your investments via SIP to average out your purchase in well managed, fundamentally strong funds capable of tapping the long term growth potential of equity markets.

The markets have already witnessed anxiety, fear, and panic and have corrected significantly to offer a decent margin of safety and opportunity for long term investors (once the sentiments improve). It could be a great time to scale up your equity exposure through some well-managed high alpha generating funds.

Editor's Note: To find the best funds with high alpha generating potential, we have developed a 'SMART Alpha Score' model. It has an additional categoriser on top of our popular 'SMART Score' process.

With optimum weightage to each parameter, which we consider important in identifying fundamentally strong funds with the potential to generate alpha, this model helps us zero in on quality names that have the ability to trump the benchmark and generate alpha returns for its long term investors.

And in our latest exclusive - The Alpha Funds Report - 2019, we have identified five high alpha generating funds selected through PersonalFN's special 'SMART Alpha' methodology.

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