Alpha is the extra return generated as compared to benchmark index. For example, in 2014 if Sensex gained 29% and our portfolios grew by 46%, it is an alpha return of 17%. Similarly in a year if Sensex falls by 10% and our portfolios lose 3 %, which is alpha of 7%.
Alpha will have mainly 2 sources – first one is the dynamic asset allocation. For example, if somebody has Rs 100 to invest today, a very important decision is the percentage to be allocated in each asset class including equities, fixed income, real estate , commodities, structured products etc. For example, today I might be recommending an 80% allocation to equities but after some time if Sensex goes up sharply, asset allocation might tilt in the favour of fixed income- dynamic allocation also facilitates profit realization, in this example in our equity position.
Second important source is selection of right schemes representing each asset class. There is a big debate on whether passive or active schemes should be preferred. Passive schemes mimic an index without any active management and their returns mimic the index so that means alpha of 0. Active schemes obviously have active management and their costs are higher. We have to come to a decision whether employing active schemes is better than passive schemes and whether selection of specific active schemes makes a difference.
To answer these questions, I have compared the returns of a few active and passive schemes during the last 5, 3 and 1 year time frameworks. I have chosen only large cap and multicap schemes so as to compare on a consistent basis. Additionally, I have taken only net returns where all costs have been deducted so that active and passive returns could be compared easily.
During the last 5 years from Dec 13, 2011 to Dec 13, 2016, passive schemes of various companies benchmarked on Nifty and Sensex have produced returns of around 10% compounded annualized. Active schemes have shown a very broad range, highest is 24% compounded annualized produced by ICICI Prudential Value Discovery and Franklin High Growth while lowest is 9 % produced by HSBC dynamic equity, IDFC imperial equity and HDFC premier multicap.
Last 3 years using the same ending date, passive schemes returned 8.5%, while the highest of 26% was generated by the same 2 schemes. Similarly, the same schemes as in 5 year period produced the lowest return of 10%.
During the last 1 year, passive schemes returned 6%, while the highest 21% return was generated by Birla Sunlife Equity. Lowest return of almost 0% was produced by Reliance Equity Opportunity. Sip returns show similar huge differences in all 3 time periods.
One can conclude that in India so far, active schemes perform significantly better than passive schemes after factoring in all costs. At the same time, active schemes have huge range of returns and therefore a correct selection is very important- It can add considerable value to the investor portfolios. While it is difficult to say which scheme will be the top most performer in the future, with a detailed incisive analysis of past performance and future trends, it is possible to select an effective combination of schemes which produces a good alpha.