What do we understand by Alpha when it comes to mutual funds? It is a way of measuring the excess returns that the fund manager generates over and above what the investor is expecting. That brings us to the next question; what is the investor expecting. Let us answer this question with a simple chart..

 

 

As the graphic above suggests, the total returns on an equity fund can be broken up into four parts. At the base level, I would at least expect to earn the risk free rate that I can get on a bond. Then I need a compensation for taking on the market risk, because otherwise you are better off putting money in an index fund. Then there is compensation for portfolio specific risk, based on the beta of the portfolio. That is what investors expect from an equity fund at the bare minimum. What even is generated above this is called the Alpha. Remember, alpha is not just about beating the market but it is about investor’s expectations. That brings us to the fundamental question; how will fund managers generate alpha (returns above expectations) in the year 2018, which is expected to be a tough year for fund managers due to a mix of domestic and global overhangs.

 

1.  Adopt a phased approach to investing..

After two frenetic years of over 25% returns on the Nifty, the year 2018 is likely to see more headwinds on the domestic and the global front. On the domestic front, there is an overhang of banking NPAs, governance issues in certain companies, inflation and interest rates concerns. Internationally, there is the worry of a potential trade war between the US and China, Fed rates are likely to rise faster while the US and Russia are indulging in sabre rattling over Syria. That means that the market is going to be extremely volatile during the year because of a mix of global and local factors. The market will give enough opportunities for fund managers to buy on dips and they will have to plan their liquidity management accordingly. In fact, if a phased approach is planned through the year then the fund manager will be in a much better position to identify attractive opportunities at the right time.

 

2.  Sell out of weakness and buy into strength..

As the global markets become more uncertain, fund managers will look to focus more on two levels of strengths. For example, there is the sectoral strength and there is strength in stocks within sectors. Basically you need to avoid stocks and sectors that vulnerable. When we talk of sectors, the obvious macro beneficiaries will be FMCG companies, consumer staples, consumer discretionary, autos etc. The strength and momentum is favour of these sectors. Within sectors focus on companies that are less vulnerable to external shocks. For example, within private banks focus on those with low level of NPAs and high NIMs. In the realty space focus on companies that are looking to monetize their commercial portfolio and using it reduce debt. When it comes to metals, focus more on sectors that are focused on domestic demand rather than on international prices. Fund managers need to adopt a very calibrated and granular approach to stock selection.

 

3.  Focus on the stocks in sectors that are likely to trigger disruption..

This can be a slightly more qualitative call for the fund managers, but that is how the alpha gets generated. For example, what are the big disruptive stories that we could see in the next 3 – 4 years? Fund managers need to start allocating to these stocks after being convinced about the merits of the business. One can focus on stocks that are on the forefront of the digitization of payment systems in India. Fund managers can also focus on companies that are providing last-mile connectivity for a plethora of electronic business. These are likely to see exponential growth. Lastly, fund managers can also look at sectors that are likely to see a lot more of domestic sourcing. Defence and insurance could be cases in point. One can also selectively look at IT for effective shift in the business model from off-shoring to on-shoring.

 

4.  Have a more defensive approach on debt..
What should debt fund manages do? It is going to be a slightly more difficult year for the bond fund managers. Firstly, global Fed rate pulls will make a case for a rise in bond yields. At the same time, the RBI is under pressure to cut rates to spur growth. A simple strategy is to keep the duration of the average bond portfolio at the middle of the range. High duration funds or floating rate funds could be a bad idea as they are the extremes of the bond spectrum. The focus of bond managers should be more to protect rather than to try anything aggressive.