Nearly three-fourth of large-cap active funds underperformed a blended (LargeMidCap) benchmark over a 10-year period, according to the 2025 report by SPIVA (S&P Indices Versus Active). In this article, we discuss two reasons that could, perhaps, explain why active funds find it difficult to consistently beat their benchmark.
Alpha is the excess returns that a portfolio generates over an appropriate benchmark. Simply put, portfolio return minus the appropriate benchmark return is equal to a portfolio’s alpha. This alpha is a function of skill and luck. Typically, two factors, knowledge and information, determine skill. Knowledge is typically acquired through a credentialing exam. Information refers to corporate news and macroeconomic developments that help portfolio managers take investment action.
The difference in skill levels among portfolio managers have narrowed over the years. This is because portfolio managers now have similar credentials (knowledge). Also, market participants can use only publicly disseminated information to take investment action. The upshot? The difference in returns between the worst-performing fund and the best-performing fund cannot be entirely explained by the difference in skill levels. That could mean luck plays an important role in alpha generation.
The issue is that a skilled portfolio manager can experience bad luck. This could be one reason for the difficulty in consistently generating alpha. The second reason could be attributed to the market structure. Markets are efficiently inefficient. That is, markets are inefficient in that assets are mispriced. Yet, markets are efficient in that such mispricing does not last long because too much money chases the same universe of stocks.
With cheap computational power and the same level of information across market participants, the opportunity for a portfolio manager to consistently pick mispriced stocks well before their competitors do is small. The above argument is not to suggest that active funds cannot generate alpha or that you should not invest in such funds. It is just that the role of luck coupled with efficiently inefficient market structure, perhaps, drive fund performance, leading to the difficulty in consistently generating alpha.
What if a fund’s underperformance (even if it were because of bad luck) coincides with the time horizon for your life goal? You may have a shortfall in your terminal wealth, the amount required to achieve a life goal. Failing to achieve a goal can cause grief. Remember, for the same level of alpha returns, negative alpha can give you more pain than positive alpha can give you happiness.
(The author offers training programmes for individuals to manage their personal investments)
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