In this column dated September 5, we discussed why active funds with high R 2 are not optimal for individual investors and how such investors can create their own active portfolio at low cost, separating benchmark returns and excess returns. In response to the article, one reader eloquently argued that a fund having strong relationship with its benchmark is desirable, as it carries low active risk, and high risk-adjusted return.
We thought the argument deserved a discussion in this column. Accordingly, this article explains the relevance of active risk and policy risk to individual investors. It then discusses when high R2 is good in the context of such risks.
Buying an active fund exposes an investor to both policy risk and active risk.
Policy risk is the risk that the investor assumes by choosing a benchmark index, say, the Nifty Index. Active risk is the risk of deviating from that benchmark.
The investor is inherently rewarded for the policy risk. That is, if an investor assumes policy risk, she can expect to receive market returns.
Active risk is not inherently rewarded; buying active funds does not necessarily mean an investor can expect to generate excess returns, as alpha is a zero-sum game.
This separation of policy risk and active risk clearly allocates investment responsibility in the portfolio management process. The investor is responsible for the policy risk - the risk of, say, the Nifty Index underperforming the broad market. This is because the investor chose to invest in the large-cap style over broad-cap index or other style benchmarks. The portfolio manager, on the other hand, is responsible if the active fund underperforms the Nifty Index - its style benchmark.
Suppose the S&P CNX 500 returns 15% in one year and the Nifty Index, 12%. If an active fund benchmarked to the Nifty Index generates 13% risk-adjusted return, the portfolio manager can be said to have delivered excess returns. The underperformance of the large-cap style is the investor`s responsibility.
Normal portfolio:
The R2 captures the relationship that a fund has with its benchmark index. An R 2 of 0.95, for instance, means that 95 per cent of the changes in fund returns can be explained by the changes in benchmark returns. This means that the fund is closely tracking its benchmark.
Is higher R2 good? The answer depends on the fund`s benchmark. Suppose an asset management firm decides to offer a fund that invests in stocks of companies having high growth and low financial leverage. Such a fund may be overweight on technology sector but may carry zero exposure to the power sector. It would be inappropriate for the fund to have a market benchmark.
The portfolio manager has to instead create a custom-tailored benchmark that captures the underlying investment process.
The fund would be expected to have a high R2 with its custom-tailored benchmark. Why? High R 2 means that the fund manager is closely following the style mandate. This enables the fund to generate higher excess returns with lower active risk.
The case is different for funds benchmarked to a market index, say, Nifty. A high R 2 (0.95 or above) means that the active fund has close relationship with the Nifty. And unlike in the case of funds with custom-tailored benchmark, the investor can buy a Nifty Index fund at a lower cost.
The R2 is relevant only if the benchmark correctly captures the portfolio`s underlying investment process. Among other factors, the portfolio should, on average, have a beta of one with its style benchmark. Inappropriate benchmarks means that the investor is not, on average, assuming policy risk associated with that benchmark. Higher R2 is desirable for active funds that have custom-tailored benchmark. It may be optimal for investors to buy index funds when active funds with market benchmark have higher R2.
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