Setting up SIP on an active fund

Deciding whether to invest in active or passive equity funds is not easy. Choosing a passive fund is simple and behaviourally optimal. Investing in an active fund can generate positive alpha. The additional cash flow generated from the positive alpha can be useful while achieving life goals. But negative alpha can hurt you more than the positive alpha of the same magnitude giving you happiness.

Yet, many invest in active funds in the hope of generating consistent positive alpha. In this article, we discuss the process you can adopt to manage the risk, and the regret associated with active funds.

Active process

Systematic investment plans (SIPs) are meant to make investment process easy. So, it is natural for an individual to set up a SIP in an equity fund to match the time horizon for a life goal. For instance, an eight-year SIP for an eight-year goal. This argument works well if the SIP is on an index fund or an ETF, as the before-cost returns on these funds must mirror that of the benchmark index.

In contrast, SIPs on active funds should be set up for 12 months at a time regardless of the time horizon for a life goal. Why? You invest in an active fund to earn positive alpha.

So, you must evaluate the fund’s performance on an annual basis. Hence, the SIP for 12 months at a time.

You must be mindful of the choices you face with active funds at the end of each 12-month period through the time horizon for a life goal. The following are the choices: You should renew SIP for another 12 months if you are satisfied with the fund’s performance. What if you are not satisfied with the performance? You can still renew the SIP if you decide to stay with the fund for another year. Otherwise, you have two choices. Either switch to another active fund or switch to a passive one.

If you switch to a passive fund, you can set up the SIP for the remaining time horizon for the life goal.

Conclusion

Every year, you must statistically test the risk-adjusted return (Sortino Ratio) of your investments in active funds.

Following this process will help you be mindful of whether each fund is generating returns according to your expectations to achieve your life goal. Your investments in active funds may have generated handsome returns in the past. It is nevertheless important that you review their annual performance.

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