9 min read
For years, investors have heard a simple argument: “Why pay a fund manager to beat the market when you can simply buy the index?” It is a fair argument. Index funds are low-cost, transparent and eliminate the risk of choosing the wrong fund manager. But there is another side to the story: some active fund managers have consistently generated alpha over long periods, particularly in categories such as mid-caps, small-caps and flexi-caps, where the market is relatively less efficient and a skilled manager has greater opportunity to differentiate.
So, should investors simply abandon index funds and move entirely into active funds? Not necessarily. The answer lies in understanding the difference between alpha and beta.
Table of Contents
Quick Summary
- Some active fund managers have consistently generated alpha over long periods, especially in less efficient categories like mid-caps, small-caps and flexi-caps.
- Returns alone don't tell the full story — a fund should be evaluated on alpha, Sharpe ratio, standard deviation, maximum drawdown and consistency of outperformance.
- Smart-beta strategies sit between passive and active investing — they follow an index but apply rules to target factors like value, momentum, quality or low volatility.
- Factors rotate: a strategy that outperformed for years, like momentum, can underperform sharply once market leadership changes.
- A well-constructed portfolio can combine active funds, traditional index funds and smart-beta strategies rather than relying on any one approach alone.
When Active Management Adds Value
Consider a few well-known active funds and how they have performed against their benchmarks over the last five and ten years:
| Scheme | Return 5 Yr | Return 10 Yr | ||
|---|---|---|---|---|
| Scheme | Benchmark | Scheme | Benchmark | |
| HDFC Flexi Cap Fund | 18% | 11% | 16% | 13% |
| Nippon India Small Cap Fund | 20% | 16% | 21% | 15% |
| Invesco India Midcap Fund | 21% | 17% | 20% | 17% |
Data as on 02-09-2026. Source: Morningstar. Direct-Growth returns; figures are approximate and vary with the date of measurement. Past performance is not indicative of future returns.
The point is not that every active fund will outperform. The point is that a good active manager can add meaningful value over long periods. For example, HDFC Flexi Cap’s 5-year CAGR has been around 18.0% compared with 11% for the Nifty 500 TRI. Invesco India Midcap Fund has also delivered a substantial long-term excess return over its benchmark.
The Power of Alpha, Compounded Over Time
So now we need to look at where this alpha actually creates value for a portfolio. If we had invested ₹1,00,000 in Nippon India Small Cap Fund at its inception in 2013, and the same amount in the Nifty Smallcap 250 TRI at the same time, we can see the magic of alpha at work.
| Scheme | Start NAV | End NAV | Invested Amount | Closing Value | Absolute Return (%) | XIRR (%) |
|---|---|---|---|---|---|---|
| Nippon India Small Cap Fund Direct | 11.00 | 209.96 | ₹1,00,000 | ₹19,06,291 | 1806.29% | 24.05% |
| Nifty Smallcap 250 TRI | 3,055.65 | 23,554.23 | ₹1,00,000 | ₹7,70,842 | 670.84% | 16.11% |
Now, your eyes might glitter at the return made — and this is exactly where investors need to look beyond just returns. A good fund should ideally be evaluated on alpha, Sharpe ratio, standard deviation, maximum drawdown and consistency of outperformance, rather than simply asking which fund delivered the highest return.
Risk Matters as Much as Return
| Scheme (5 Year) | Scheme | Benchmark | ||||
|---|---|---|---|---|---|---|
| SD (%) | Sharpe Ratio | Max Drawdown (%) | SD (%) | Sharpe Ratio | Max Drawdown (%) | |
| HDFC Flexi Cap Fund | 12.94 | 0.94 | -13.32% | 14.42 | 0.40 | -18.59% |
| Nippon India Small Cap Fund | 17.53 | 0.81 | -24.21% | 20.16 | 0.58 | -26.61% |
| Invesco India Midcap Fund | 17.43 | 0.88 | -20.07% | 16.88 | 0.72 | -21.12% |
Data as on 02-09-2026. Source: Morningstar.
Looking beyond the return, all the funds that outperformed their benchmark on a return basis have also outperformed on a risk and risk-adjusted return basis. Over the last five years, HDFC Flexi Cap Fund has generated 0.94 units of additional return for every 1.00 units of additional risk. By comparison, the Nifty 500 TRI generated only 0.40 units of additional return for every 1.00 units of additional risk. The objective is not to find the fund that took the highest risk — it is to find the fund that generated the best risk-adjusted return.
Why Not Just Build a Portfolio of Active Funds?
If active funds can generate alpha, why not simply build a portfolio of active funds? Because not all returns need to come from active stock-picking. The answer lies in smart-beta strategies and ETFs. A smart-beta strategy changes the way an index selects and weights stocks — instead of simply giving more weight to bigger companies, it uses a predefined rule to give more importance to companies with a particular characteristic, or factor.
Today, investors can also access smart-beta strategies and ETFs based on factors such as value, momentum, quality, low volatility, alpha and equal weight:
- Value: Gives more weight to stocks that look relatively cheap.
- Momentum: Gives more weight to stocks that have been performing strongly.
- Quality: Gives more weight to companies with stronger business and financial characteristics.
- Low Volatility: Gives more weight to stocks whose prices have historically moved less.
- Alpha: Selects stocks based on characteristics associated with higher excess returns.
In very simple terms, smart beta does not ask a fund manager, “Which stocks do you think will perform best?” Instead, it says, “Let’s create a rule for the type of stocks we want and follow that rule consistently.” This is why it is called rules-based investing.
Think of the Nifty 500 as the whole menu of 500 companies. The Nifty 500 Value 50 is like picking 50 companies from that menu based on a specific rule: “Give me companies that show value characteristics.” This is what makes it a smart-beta strategy — it uses a predefined rule to target a particular factor rather than simply tracking the broad market. Traditional index investing follows the philosophy of simply following the market, which is beta. Active investing tries to beat the market, which is alpha. Smart beta follows the market but applies a different set of rules.
In simple terms, smart beta sits between passive and active investing. It follows an index, but instead of simply owning the market, it uses rules to target factors such as value, momentum, quality or low volatility — and this creates an interesting opportunity.
Factors Rotate — Nothing Works Forever
So, does that mean we should add every factor-based index fund or ETF to our portfolio? Not necessarily. Just like a particular sector or investment theme can perform well during one period and struggle during another, factors also have their time to shine — but not forever. A factor that has performed strongly in the past may not continue to lead in the future. This creates an important risk: choosing the wrong factor at the wrong time can hurt portfolio returns.
The table below shows exactly how differently various factors can perform across different market cycles.
| Year | Momentum | Value | Low Volatility | Quality | Nifty 500 TRI |
|---|---|---|---|---|---|
| 2005 | 66.49% | 23.12% | 44.34% | 33.91% | 38.77% |
| 2006 | 58.84% | 10.62% | 37.13% | 23.21% | 36.16% |
| 2007 | 126.71% | 101.55% | 39.46% | 39.34% | 64.58% |
| 2008 | -64.88% | -58.66% | -43.44% | -50.03% | -56.54% |
| 2009 | 57.19% | 124.08% | 84.80% | 113.28% | 90.96% |
| 2010 | 19.34% | 27.62% | 27.13% | 24.04% | 15.27% |
| 2011 | -21.58% | -39.48% | -20.02% | -20.62% | -26.40% |
| 2012 | 49.43% | 28.77% | 29.68% | 32.56% | 33.48% |
| 2013 | 11.09% | -17.66% | 5.03% | 15.65% | 4.82% |
| 2014 | 68.26% | 72.37% | 32.88% | 45.61% | 39.30% |
| 2015 | 10.25% | -10.12% | 6.43% | 6.86% | 0.22% |
| 2016 | -2.78% | 20.84% | 0.54% | -1.29% | 5.12% |
| 2017 | 67.16% | 42.36% | 30.08% | 31.61% | 37.65% |
| 2018 | -11.75% | -28.81% | 5.60% | -3.69% | -2.14% |
| 2019 | 7.82% | -15.78% | 6.57% | 0.09% | 8.97% |
| 2020 | 19.82% | 6.01% | 22.08% | 25.43% | 17.89% |
| 2021 | 75.77% | 50.09% | 18.06% | 27.00% | 31.60% |
| 2022 | -8.32% | 18.93% | 5.47% | -4.57% | 4.25% |
| 2023 | 46.66% | 61.01% | 32.20% | 40.34% | 26.91% |
| 2024 | 25.56% | 17.66% | 14.92% | 21.75% | 16.24% |
| 2025 | -8.30% | 14.97% | 14.63% | -4.58% | 7.76% |
| 2026 | 3.44% | 2.16% | -4.31% | 4.12% | -2.00% |
Source: niftyindices.com
Consider momentum investing: it performed exceptionally well in the years leading up to 2022. But when market leadership changed, the same factor struggled significantly — in 2022, the Nifty 500 Momentum 50 index fell by -8.32%, while the Nifty 500 Value 50 index gained around 18.93%. The lesson here is that the factor that worked yesterday may not be the factor that works tomorrow.
The same pattern shows up during severe market corrections. During the 2008 financial crisis, momentum and alpha strategies experienced extremely sharp drawdowns. This is why blindly choosing a smart-beta ETF based on its recent returns can be dangerous — a good factor can become a bad investment when used at the wrong point in the market cycle.
Active, Passive or Both?
So, active or passive? Perhaps the better question is why choose only one. A well-constructed portfolio can combine all three:
- Active funds for the potential to generate alpha through fund-manager skill.
- Traditional index funds for low-cost, broad-market exposure.
- Smart beta or ETFs for targeted exposure to factors such as value, momentum, quality or low volatility.
The proportion allocated to each can change depending on the investor’s risk profile, investment horizon, existing portfolio and market environment.
Choosing the Right Beta Matters as Much as Choosing the Right Fund
And this brings us to the most important point: choosing the right beta is as important as choosing the right fund. Investors often spend considerable time trying to identify the best mutual fund, but much less time thinking about what type of market exposure they actually need:
- Should the portfolio have more value exposure today?
- Should momentum be increased?
- Is quality becoming more attractive?
- Should downside protection take priority?
These are not questions that can be answered by looking at last year’s returns — they require analysis of valuations, market cycles, risk, correlations, factor behaviour and portfolio positioning.
This is precisely why portfolio construction is more than simply picking a list of good mutual funds. The objective is not to predict which fund will be number one next year. The objective is to construct a portfolio where different sources of return can work together across different market cycles. A combination of active funds, traditional beta and carefully selected smart-beta strategies can therefore be more effective than relying entirely on any one investment philosophy.
Conclusion
Ultimately, the biggest decision may not be “Which fund should I buy?” It may be “Which combination of alpha and beta is right for my portfolio today?”
Past performance is not indicative of future returns. Mutual fund investments are subject to market risks. Investors should evaluate investments based on their individual objectives, risk profile and investment horizon.
