Active Mid-Cap Funds vs. Indexing: Where Does the Alpha Hide?

Alpha in mutual funds is the “extra return” added by a fund manager in comparison to its benchmark index (after considering the risk taken). For example, if the benchmark gives a 10% return and the mutual fund gives a 12% return, the extra 2% is called alpha.

This additional return may indicate the fund manager made quality investment decisions that allowed the fund to perform better than the benchmark. However, such higher returns are worth considering only if they are not achieved by taking excessive risk. 

Alpha is usually associated with “actively managed mutual funds”. In these schemes, the fund manager actively selects stocks and decides when to buy or sell. This creates an opportunity to outperform the benchmark and generate positive alpha.

Want to learn more? Read this article to specifically understand which scheme, “active mid-cap funds vs. index funds,” offers more alpha and why. Lastly, know about the Tata Mid Cap Fund offered by Tata Mutual Fund ™ and its primary features. 

Mid-cap mutual funds “actively” invest at least 65% of their assets in equity and equity-related instruments of mid-cap companies ranked between 101st and 250th (in terms of full market capitalisation). These companies are usually past the early startup stage but may still have growth potential. 

A mid-cap index fund is its “passive counterpart”, which tracks a mid-cap market index, such as Nifty Mid-Cap 150 or S&P BSE Mid-cap. The fund invests in the same companies and in the same proportion as the index it follows, subject to tracking error.

Realise that alpha can be generated when there is “active management”. 

Mid-cap investment funds are managed by professional fund managers who actively select stocks. Their goal is to identify companies that may grow faster than the benchmark. 
 

In contrast, index funds simply copy the index. They do not try to beat it, so their alpha is usually “zero”. Additionally, some more reasons why mid-cap funds may generate higher alpha than mid-cap index funds are:
 

1. Ability to Select High-Quality Companies and Avoid Weak Ones

Mid-cap index funds must invest in all stocks included in the index, including “weak performers”. Such underperforming companies may have weak fundamentals, such as:

• Declining revenue

• Low or falling profit margins

• High or increasing debt

• Weak cash flow

• Poor return on equity (ROE)

In contrast, an active mid-cap fund manager can study financial statements, business models, and industry trends to select stronger companies and avoid weaker ones. This “selective approach” may improve the chances of generating returns above the benchmark, which could lead to positive alpha.

2. Early Identification of Future Market Leaders

Many mid-cap companies have the potential to become large-cap companies in the future. Fund managers of active schemes may conduct detailed research to identify such businesses early (before their growth is fully reflected in stock prices). 

Whereas index funds may include these companies only after their market value increases. Thus, again, active funds may benefit earlier and generate higher alpha.

3. Flexibility to Adjust Portfolio Based on Changing Conditions

Mid-cap category fund managers can change their portfolio when they see risks or new opportunities. For example, they can:

• Reduce exposure to companies facing declining demand and

• Increase allocation to sectors showing growth

Index funds do not have this flexibility as they must follow the index structure. This ability to make portfolio changes allows active mid-cap funds to generate a potentially higher alpha.

4. Mid-cap stocks are less closely tracked by the market

As per industry understanding, mid-cap companies receive less attention from analysts and institutional investors compared to large-cap companies. Due to this, their stock prices may not always reflect their “true value”. 

Now, mid-cap mutual fund managers can:

• Identify undervalued stocks through research +

• Invest in them before the broader market recognises their potential. 

Later, when the market eventually corrects the pricing, these stocks may deliver higher returns, helping the fund generate alpha.

The Tata Mid-Cap Fund is an open-ended equity scheme predominantly investing in mid-cap stocks. The investment objective of the scheme is to provide income distribution and/ or medium to long-term capital gains. Investment would be focused on mid-cap stocks. However, there is no assurance or guarantee that the investment objective of the scheme will be achieved. The scheme does not assure or guarantee any returns.
 

For a better understanding, let’s check out some key features of the Tata Mid-Cap fund and its asset allocation patterns:

Asset Allocation and Risk Profile

“Indicative” Investment Restrictions and Limits (as per SEBI Guidelines)

So now you know what alpha is and which scheme among active mid-cap funds and mid-cap index funds carries higher alpha-generating potential. Alpha refers to the extra return a fund generates above its benchmark due to the fund manager’s active decisions. 

Due to active management, a mid-cap mutual fund may have a higher potential to generate alpha. That’s because it can actively pick + rotate mid-cap companies based on their fundamentals and prevailing market conditions.

In contrast, a mid-cap index fund is passive and must invest in the same companies (in the same proportion) as the index. The changes to its portfolio can be made only during index rebalancing. This increases the likelihood of remaining invested in underperforming companies with weak fundamentals, as the fund cannot remove them unless the index itself changes.

The views mentioned above are for information & educational purposes only and do not construe to be any investment, legal, or taxation advice. Investors must do their own research before investing. The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. Any action taken by you on the basis of the information contained herein is your responsibility alone, and Tata Asset Management Pvt. Ltd. will not be liable in any manner for the consequences of such action taken by you. Please consult your Mutual Fund Distributor before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund. There are no guaranteed or assured returns under any of the schemes of Tata Mutual Fund.