Why Active Fund Investing is so hard?

Would you consider investing in a fund that has significantly trailed its benchmark over the past one year? Many would likely hesitate, although some might still be swayed if that fund has a strong historical track record.

Now, let’s consider a scenario where a fund has consistently underperformed its benchmark over the last three or five years. Would you still be eager to invest? It’s doubtful that many investors would be willing to take that risk.

This is actually one of the biggest problems with active investing.

When we invest in an active fund – one that aims to outperform the benchmark index – most of us understand  that it might underperform the index. However, when faced with the reality of prolonged underperformance, maintaining faith in the fund becomes incredibly challenging. Especially because we’ve seen many cases where active fund managers started strong but then lost their edge and never bounced back.

But at the same time we know that what is definitely required to achieve above average returns is to stick with the active funds even when they are underperforming. Take Warren Buffett, for example. If you’d invested just one dollar in his company, Berkshire Hathaway,  back in 1965, you’d have over $36,000 now. Compare that to about $300 if you’d stuck with the S&P 500.

But getting those great returns means enduring as many as 40% of the years when Berkshire Hathaway was trailing the S&P. Even during a five-year stretch from 1994 to 1999, when Buffett wasn’t betting on tech companies because he didn’t get how they worked, he underperforming by more than 70%. And there have been other such 5 year periods when he underperformed.

Consider our own portfolio, Gulaq Gear 6. It’s had its ups and downs too in its relatively small track record of about 4 years. Since its going live in May 2020, it has underperformed (produced negative alpha) in 15 months but outperformed (produced positive alpha) over Nifty50 in 30 months. Now, if we look at yearly rolling returns, Gulaq has actually churned out a positive alpha in every 12 month period since its launch.

Generating alpha is tough. Doing it year after year consistently is even tougher.

The kind of wealth we all dream of can only be created when we invest for decades and ignore all the ups and downs. The stuff happening in the stock market right now? It’s just noise. The smart move is to stick to your investment plan, no matter what’s going on out there.

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