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Sunday, Jan 30, 2011
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It is good to see yet another passive investment product offered to the investors recently — a much-needed ETF on the mid-cap index. It is still early days to state that asset management firms in India are beginning to see virtues of offering passive products. Firms would continue to offer active products as long as there is demand for active management. The question is: Why do individual investors prefer active management?
This article explains the primary drivers that enable active funds generate alpha. It then shows why both discerning and naïve investors prefer to invest in such active mandates.
Active mandate requires the asset management firm to beat the benchmark index. Such a mandate presupposes that the firm (through its portfolio managers) has the following:
One, the firm has a view on securities — whether they are undervalued or overvalued. Two, the firm has good predictive ability. That is, there is a strong correlation between its views and the actual outcome. Three, the firm's alpha strategy is scalable. That is, the firm can apply its alpha strategies even if its assets under management increase significantly. And four, the firm is able to optimally rebalance its portfolio to capture unrealised alpha.
It is clear from the above that alpha generation is possible only if the firm successfully applies all four factors. The problem is that a firm's forecast is not always correct. Moreover, as a firm increases its assets under management, alpha gradually fades away and merges with market returns or beta. This makes it difficult for active mandates to be continually rewarding.
Empirical evidence suggests that some among the universe of active mandates will be successful every year. The problem is that the composition of the positive alpha cohort will change continually. This makes it difficult for investors to choose an active fund.
The question is: Why then do investors prefer active mandates?
We believe that two types of investors prefer active mandates — the naïve investors and the overconfident ones. Naïve investors “chase” returns. And this essentially means that such investors are either nudged by fund advertisements or choose funds based on past performance.
Now, research has shown that past performance is not necessarily an indicator for the future. It is, hence, important for such investors to understand the risk-return trade-offs from active mandates. Investor awareness initiatives could help this class of investors make more optimal choices.
Then, there is the other class of investors who are financially literate. This class of investors understands the risk involved in selecting such mandates — the risk of the fund underperforming the benchmark should any one of the four drivers fail. Yet, they prefer such mandates. Why?
We believe that these investors consider themselves smart enough to choose the “right” active mandate. That is, they believe they have the skill to choose sustainable alpha-generating funds. If their forecast fails, more often than not, these investors keep their holdings, for selling would lead to realised losses not to mention regret of making a wrong choice.
One way to moderate such overconfidence is to keep a journal of investment success and failures. This would be proof for the investor as to whether he or she, indeed, has the skill to choose sustainable alpha funds.
Financial and psychological awareness programs would help most investors consider the risk-return trade-offs before buying active mandates. The risk of active mandates is not just that they will underperform their benchmarks but they will do so gradually till the negative alpha is significant and recovering losses become difficult within the investment horizon. ETFs make economic sense viewed in this backdrop.
This does not mean that active mandates do not have a place in the investment portfolio. Such mandates should essentially constitute the satellite portion of the core-satellite portfolio- the sub-portfolio that primarily “explores” alpha generators.
(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at firstname.lastname@example.org)
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