Points to think about when setting up SIPs

Evaluate the performance of an active fund each year and renew the SIP when you are satisfied with the fund’s returns

Evaluate the performance of an active fund each year and renew the SIP when you are satisfied with the fund’s returns

In previous columns, we discussed the risks associated with active funds. Given these risks, if you decide to invest in an active fund for your goal-oriented portfolio, how should you set up your investment process? In this article, we discuss why the investment process you set up for active funds should be different than that you set up for ETFs or index funds.

Active versus passive

An active fund is expected to provide higher returns than its benchmark index. This excess return over the benchmark is referred to as alpha. To generate alpha, an active fund manager must be overweight stocks expected to perform well and underweight stocks that may underperform relative to the benchmark index. This results in an active risk.

An active fund therefore carries two risks – active risk and market risk. Active risk could cause the fund to underperform its benchmark and generate negative alpha. For example, a fund might return 10% versus its benchmark return of 12% (two percentage points negative alpha). Market risk could result in the Fund achieving negative (total) returns. For example, the fund could generate a return of minus 10%. In contrast, a passive fund (an ETF or index fund) is only exposed to market risk.

Now, market risk is unavoidable when investing in stock mutual funds. However, because it’s an asset with higher expected returns, investing in stocks is important if you’re looking to balance your current lifestyle with savings. But what about active risk? You can control active risk based on your choice of active fund. Because of this, your investment process for an active fund should be different than that for a passive fund.

The investment process is simple when buying passive funds. You must create a systematic investment plan (SIP) that aligns with a life goal time horizon. So if the time horizon for a life goal is eight years, then the SIP (for both stock funds and bank deposits) must be established for eight years.

However, if you choose active funds, the SIP must be set up one year at a time. Why? The more consistently an active fund generates alpha, the lower the active risk. But alpha is a function of both luck and skill. And it is very difficult to distinguish the two.

This means that a fund can generate negative alpha after you buy the fund even if it has generated positive alpha in the past. So you have to evaluate the performance of an active fund every year. If you are satisfied with the fund’s return, you must renew the SIP for another year. Otherwise, you should analyze and select another active fund.

Switching to another active fund now may expose you to future regrets.

How? Suppose you are currently invested in Fund A. Dissatisfied with the performance, you switch to Fund B. What if Fund A subsequently performs well and Fund B performs worse? If you want to avoid this later regret, you should switch to a passive fund.

Conclusion

Active funds can achieve higher returns than their reference index when the market is rising and lower losses than the benchmark when the market is falling. But there is a trade-off – choosing such funds is not easy. You therefore need to set up a SIP for a block of 12 months to continuously evaluate the fund. Therefore, each year of the time horizon becomes a decision point for your life purpose.

Such decision points are important for an optimal decision. If you switch active funds in three out of five years, this is a clear signal that such funds are not suitable for you. You should consider switching to a passive fund; This is because passive funds rated by the same index have similar returns and do not require decision points.

(The author offers training programs for individuals to manage their personal investments.)

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