When you think of index funds, the first thought that likely comes to mind is a straightforward, low-risk, passive investment. But what if I told you there’s another type of index fund that aims to outperform the market?
That’s where alpha index funds come into play.
But should you, as a beginner investor, consider adding alpha index funds to your portfolio? Let’s break it down step by step. Let’s see how they work, their historical performance, associated risks, and when you should invest in them.
Estimated read time: 5 minutes and 24 seconds
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Buckle up. Here we go!
What Are Alpha Index Funds?
Alpha index funds differ from the regular index funds most people are familiar with. While a traditional index fund simply tracks a broad market index (like the Nifty 50 or Sensex 30), an alpha index fund tries to do something more ambitious in passive investing—it aims to outperform the market, also known as generating “alpha.”
In investment terms, alpha is the measure of excess returns generated over a benchmark index. For example, if an alpha index fund outperforms the Nifty 50 by 2%, that 2% is the alpha.
How Are Alpha Index Funds Formed?
An alpha fund is typically formed using a strategy called factor-based investing. This involves selecting stocks based on specific characteristics that have historically led to superior performance.
- Jensen’s Alpha: This is a key metric used to form alpha funds. It measures the excess return of an investment relative to its expected return based on its risk level. Stocks with positive Jensen’s Alpha are prioritized for inclusion in the fund.
- Selection Process: For example, the Tata Nifty 200 Alpha 30 Index Fund selects the top 30 stocks from the Nifty 200 Index based on their Jensen’s Alpha scores. This means that only those stocks that have consistently outperformed their benchmarks are included.
- Ranking Stocks: The selected stocks are ranked according to their alpha scores. Only the top-performing stocks are included in the fund.
- Regular Rebalancing: The fund is typically reviewed and adjusted quarterly to ensure it stays aligned with its strategy.
Historical Performance: Alpha Index Funds vs. Broader Index Funds
Let’s get to the burning question—how have alpha index funds performed compared to broader index funds like the Nifty 50 or the Sensex 30?
Over the past 10 years, the Nifty 200 Alpha 30 has returned 25.2% annually, whereas its benchmark Nifty 200 has returned only 14.6%. (Source)
That means if you had invested ₹1 lakh in the alpha index 10 years ago, it would have grown to around ₹9.5 lakhs. The same amount in the Nifty 200 would have grown to just ₹3.9 lakhs.
So, yes, historically, alpha investing has shown convincing performance, but it comes with certain caveats.
- Outperforming Broader Indices: There are periods where alpha index funds have outperformed broader index funds (Nifty 50, Nifty Midcap 150, etc.). For example, in bullish markets when the economy is growing rapidly, and investors are optimistic, alpha stocks tend to ride the wave and deliver higher returns compared to the broader index.
- Underperformance in Volatile Markets: On the flip side, alpha funds underperform in highly volatile or bearish markets. When the market sentiment changes rapidly, high-flying stocks can quickly fall out of favour, and this affects the alpha funds negatively. In such periods, broader index funds may hold up better.
However, it’s essential to note that past performance is not indicative of future results. Thus, while alpha index funds have shown the potential for higher returns, they are also more prone to short-term fluctuations.
What Are the Risks of Alpha Index Funds?
While the potential for higher returns might sound tempting, it’s crucial to understand the risks involved. Here’s how alpha funds compare to broader index funds in terms of risk:
- Higher Volatility: Alpha funds are more volatile than broader index funds. When market trends change rapidly, these funds experience sharper declines. For example, over the past 10 years, the Nifty 200 alpha 30 had an annualised volatility of 20.4%. In contrast, its benchmark the Nifty 200 had an annualised volatility of only 16.7%. This volatility gap between the broader and alpha funds grows wider in the short term.
- Underperformance Risk: There’s always the chance that the fund’s strategy doesn’t work as well as expected, leading to returns that are lower than the broader market. This is a significant risk, especially in times of economic uncertainty or market downturns.
- Concentration Risk: Some alpha funds may concentrate investments in certain sectors or types of companies, which can increase volatility and risk.
- Liquidity risk: Unlike momentum index funds, alpha index funds don’t focus on the stock market free-float. Therefore, if the fund invests in less liquid stocks to generate alpha, it might face challenges during market stress.
Momentum Index Funds vs. Alpha Index Funds: What’s the Difference?
You might be wondering: how are alpha index funds different from momentum index funds, another niche category of funds? While they both aim to outperform the market, the strategies they use are quite different.
Momentum Index Funds:
- The primary stock selection criteria are based on momentum score and free-float market capitalisation
- Because of free-float criteria, momentum funds have a higher concentration of large and mid-cap stocks.
- Low volatility compared to alpha index funds.
- The index is rebalanced half-yearly.
Alpha Index Funds:
- The primary stock selection criteria are based on the alpha score.
- The alpha index doesn’t focus on free-float hence the alpha factor changes its market cap exposure based on the market cycle.
- High volatility compared to momentum index funds.
- The index is rebalanced quarterly.
The key difference lies in the stock selection criteria. While most alpha index funds have outperformed momentum index funds, alpha funds carry a higher risk than momentum funds.
When Should You Consider Investing in Alpha Index Funds?
So, should you invest in alpha index funds? Here are some conditions where investing in alpha index funds might make sense:
- You Have a Higher Risk Appetite: If you’re comfortable with more volatility and can stomach short-term losses for the potential of long-term gains, alpha index funds could be a good fit.
- You’re Looking for Higher Returns: If you’re not satisfied with market-matching returns and are willing to take on additional risk for the chance of higher returns.
- You Believe in a Bull Market: Alpha index funds tend to perform well during periods of strong economic growth. If you’re optimistic about market conditions, these funds could outperform broader index funds.
- Long-Term Investment Horizon: Alpha index funds work best when you can give them time to realise their potential. If you have a long-term investment horizon (over 7 years), you’re more likely to benefit from the periods when alpha funds outperform.
- Diversification: If you already have a solid, diversified portfolio of broader index funds, adding an alpha index fund can provide exposure to high-growth stocks. This can help boost your overall returns, especially in bullish markets.
When Should You Avoid Investing in Alpha Index Funds?
- Short-term Goals: If you’re investing for short-term goals (say, within 2-3 years), alpha index funds may not be the best choice. Their volatility can cause significant fluctuations in your investment value, making them unsuitable for short-term financial needs.
- In Bearish or Uncertain Markets: When the market is facing uncertainty or is in a bearish phase, alpha funds may not perform well. Broader index funds offer better protection in such environments.
- Low-Risk Tolerance: If you prefer steady, lower-risk investments, alpha index funds may not be suitable for you. The volatility and sector concentration of these funds can lead to significant ups and downs, which might be unsettling for conservative investors.
- For Core Portfolio: Alpha index funds are not ideal as the core of your portfolio. The core of your portfolio should be stable, diversified, and designed for long-term growth. Alpha funds are better suited as a satellite investment, complementing a well-diversified core portfolio.
Final Thoughts
Alpha index funds present an intriguing option for investors looking to outperform the market, but they come with their own set of risks. While they have the potential to deliver higher returns, they can also experience higher volatility and periods of underperformance compared to broader index funds.
Before you dive into alpha index funds, it’s essential to assess your risk tolerance, investment goals, and market outlook. If you’re willing to accept the risks in pursuit of higher returns, alpha index funds can be a valuable addition to your portfolio.
But for most beginners, it’s wise to first build a strong foundational core portfolio with traditional/broader index funds before exploring more specialized investments like alpha index funds.
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Still Curious?
If you are like us, who likes to analyse a little more or check out content in different formats, well you are in luck. Below you can find some suitable content we found.
Value Research – Momentum & alpha funds: Better than even small-cap funds?
ET Money – Alpha vs momentum funds: Where should you invest?
Note: We don’t have any affiliation with them. We are sharing links only for educational purposes. The opinions expressed by them belong solely to them and do not reflect the views of Vrid.
