The core question: is the fund beating its benchmark because the manager is skilled, or because the portfolio is tilted toward a priced risk factor (size, momentum, quality, value) that happened to do well?
This is the most common error. A mid-cap heavy fund benchmarked against the Nifty 50 will show large "outperformance" during any mid-cap rally. That is the size factor premium, not skill. [6]
Rule: Benchmark a mid-cap fund against the Nifty Midcap 150. A quality-tilted large-cap fund against the Nifty Quality 30. Outperformance vs. the category-appropriate benchmark is the only meaningful starting point.
Every fund return can be split: [4]
$$\alpha_a = r_a - \beta_a \cdot r_b$$
Worked example from the module:
| Item | Value |
|---|---|
| Fund return | 16% |
| Nifty 50 return | 14% |
| Fund beta vs. Nifty 50 | 0.95 |
| Jensen's alpha | 16% − (0.95 × 14%) = 2.7% |
But 2.7% may still be factor beta if the fund is mid-cap or momentum-heavy. A single-beta decomposition overstates true alpha.
The proper alpha controls for all systematic factors: [1]
$$R_i = \alpha_i + \beta_{i,1}f_1 + \beta_{i,2}f_2 + \ldots + \beta_{i,K}f_K + \epsilon_i$$
If $\alpha_i \approx 0$ after adding factors like momentum, quality, and size, the outperformance is entirely explained by factor tilts. The manager is charging active fees for what you could buy in an ETF at 0.12–0.35%. [3]
Practical shortcut: Compare the fund's return to the relevant factor index (e.g., Nifty 200 Momentum 30 for a fund with momentum tilt). If the fund barely beats or trails the factor index, there is no residual alpha.
Raw alpha is not enough — you need to know how efficiently it is generated: [5]
$$IR = \frac{E[\alpha]}{TE}$$
where $TE$ is the Volatility) — definition">Standard Deviation (Volatility) — definition">standard deviation of active returns (Tracking Error — definition">tracking error).
| IR Level | What it means |
|---|---|
| < 0 | Destroying value |
| 0.0 – 0.3 | Barely justifying fees |
| 0.3 – 0.5 | Marginal — only at low TER |
| 0.5 – 0.8 | Genuine, consistent skill |
| > 0.8 | Excellent |
Two funds both beat the benchmark by 3%/year. Fund A has TE of 12% → IR = 0.25. Fund B has TE of 4% → IR = 0.75. Fund B's manager is demonstrably more efficient. [5]
Threshold to remember: IR > 0.5 over 5+ years is the bar for justifying active fees. [2]
A fund might show a high average alpha because it had one exceptional year when its style factor was in favour (momentum funds in 2023, quality funds in 2017). Ask: [1]
If the fund's active share is below 50%, it is a closet indexer — it cannot generate enough independent bets to produce genuine alpha, regardless of what the marketing says. [8]
| Active Share | Reading |
|---|---|
| < 50% | Closet indexer — avoid paying active fees |
| 50–70% | Moderate conviction |
| > 70% | Worth evaluating on IR and consistency |
Is the $\alpha_i$ positive and statistically significant after controlling for the relevant factor benchmark, with IR > 0.5, consistent across periods, and high enough to justify the fee differential over a factor ETF?
If yes: the fund may deserve an allocation. If no: you are paying 1.5% for what a 0.20% factor ETF already delivers. [1]
Apply this → Go to Explore Funds — sort by 5-year Information Ratio. For your shortlisted funds, check the category benchmark and cross-reference with the relevant factor index return over the same period.