Alpha in Mutual Funds: Understanding How to Generate Alpha & Overcome Challenges

Alpha generation is one of the primary goals while investing in mutual funds, especially active funds. Generating alpha may look easy, but it is not and warrants tremendous expertise. Alpha generation is the primary responsibility of the fund manager and his team.

Alpha Meaning in Mutual Funds

Alpha is the extra return a fund earns above its benchmark index. The alpha ratio in mutual funds shows how much the fund has been able to deliver above its benchmark. For instance, if a fund's alpha is 3, it means the fund has outperformed its index by 3%. On the other hand, a negative alpha is an indication of underperformance.

Strategies to Generate Alpha in Mutual Funds

Alpha funds deploy a wide range of strategies to generate returns above the benchmark. Some of them are:

• Wise Stock Selection

Mutual funds invest in a basket of stocks and prudent stock selection goes a long way in ensuring alpha generation. Alpha mutual funds generally have undervalued stocks or those which have growth potential. Having these stocks position the fund to outperform its benchmark in the long run.

• Sector Rotation

Just like stock selection, alpha generation also warrants targeting the right sector. This is because different sectors perform well at various times. Generally, sectors like technology and consumer discretionary tend to do well in a booming economy, while healthcare and utilities may perform well during downturns. Mutual funds can enhance alpha by rotating investments between different sectors with changing economic conditions.

• Prudent Risk Management

Generating alpha also entails effective risk management. Through diversification and avoiding over-concentration in one particular sector, mutual funds can minimise risk and produce steady returns that can outperform the index.

Challenges in Generating Alpha

While alpha generation is the goal for every actively managed fund, it comes with its set of challenges. Some of them are:

• Market Efficiency

Thanks to the Internet boom, information spreads at lightning speed. The reflection on stock prices is almost immediate. This makes it highly challenging for fund managers to find undervalued stocks and consistently generate alpha.

• Behavioural Bias

Fund managers are humans, and human psychology can interfere with investment decisions. Even the most professional fund managers can fall prey to behavioural biases such as overconfidence, loss aversion and herd mentality. All of these can lead to suboptimal returns in the long run.

• Regulatory Constraints

Mutual funds are under Sebi’s purview, which has strict asset allocation and risk exposure guidelines. The regulatory constraints can limit a fund manager’s ability to generate alpha. Time and again, fund houses have to follow the diktat laid by Sebi, which can constrain a fund’s ability to generate alpha.

• Intense Competition

The mutual fund industry is intensely competitive. With new funds being launched and the same market being analysed by many professionals, alpha generation is increasingly becoming tough. Being market-linked, mutual funds are subject to various risks, which makes the task even harder.

Conclusion

While investing in alpha mutual funds can help you generate returns higher than the benchmark index, note that choosing and investing in a fund goes much more than alpha. You need to look at other factors, such as the fund manager’s track record, your risk tolerance and the fund’s alignment with your goals.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.