Do Active Funds in India Benefit from Higher Active Risk Exposure?

Fund managers typically follow a factor or a style of investing and aim to construct portfolios by balancing active sector exposures and stock-selection risks within a sector. Tracking error is one way to measure a fund’s deviation from its respective benchmark to determine how “active” it is.

As measured in the SPIVA® India Year-End 2018 Scorecard, in the Indian Equity Large-Cap category, fund managers undertaking higher active risk posted higher returns. The large-cap category is generally the most researched and most efficient segment in any market, and it is therefore extremely challenging to generate outperformance in the active space. As shown in Exhibits 1 and 2, in the large-cap category, fund managers who took higher risk (had a higher tracking error) delivered superior returns relative to their peers. In other words, funds taking higher active risk were compensated with higher excess return and thus, had higher information ratios. But looking at the category average, active funds had little to offer in terms of excess returns.

On the other hand, in the Indian Equity Mid-/Small-Cap category, funds with lower tracking error or funds that were more closely aligned to the benchmark outperformed their peers. Alternatively, Exhibits 1 and 2 imply that fund managers in this category who took on higher active risk in their portfolios found it challenging to get their active bets correct, thus witnessing lower information ratios. Having said that, we see that active fund managers in this category, on average, still generated excess returns over the benchmark.

In summary, in the Indian Equity Large-Cap category, active funds with higher active risk have historically offered positive excess returns and positive information ratios, but the overall category average shows that the category has underperformed the benchmark. Interestingly, in the Indian Equity Mid-/Small-Cap category, funds with lower tracking error have offered better excess returns and thus higher information ratios, with a mean excess return of 103 bps.

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