Direct Alpha

KS-PME tells you, as a ratio, whether a fund beat the market. Investors usually want the answer as a rate: by how many percentage points a year?

Direct Alpha gives that. The workbook calls it "a slight variation over the KS-PME method" which "measures the superior/inferior performance of the AIF as a percentage over market returns thereby quantifying the alpha directly".

The mechanics are almost identical. Every capital call, distribution and the closing NAV is first carried forward at the market index's returns to the valuation date, exactly as for KS-PME. But instead of dividing the totals, you run an IRR on those market-adjusted cash flows. The rate that comes out is the alpha: positive means the fund outperformed the market, negative means it lagged.

The workbook reuses the KS-PME data (Illustration 6.5, Rs crore):

• The -44.55 is -20 × 1.18 × 1.14 × 1.16 × 1.22 × 1.17; the -56.63 is -30 × 1.14 × 1.16 × 1.22 × 1.17.
• Fund IRR on the raw net cash flows (-20, -30, 0, 0, 140) = 35%.
• Direct Alpha = IRR of the future-value flows (-44.55, -56.63, 0, 0, 140) = 10%.

Both are worked with the IRR function in Excel. The workbook then reads the result as: the fund outperformed the market, "which has an IRR of 25% (35% − 10%)".

In the summary table, Direct Alpha is the market-adjusted rate-of-return measure, sitting beside KS-PME (market-adjusted total return), IRR and MIRR (absolute rate) and TVPI (absolute total).

Step 1: FV of each flow = flow x product of (1 + market return) from its date to the valuation date
Step 2: Direct Alpha    = IRR of (FV of calls, FV of distributions, NAV at valuation date)

Workbook reading: market IRR = Fund IRR - Direct Alpha

Illustrative figures. Take the same Narmada Opportunities Fund used for KS-PME: calls of Rs 50 crore (Y0) and Rs 50 crore (Y1), a Rs 30 crore distribution at Y3 and Rs 110 crore NAV at Y4, with index returns of 12%, 8%, 15%, 10% and 14%.

Raw net flows          : -50, -50, 0, 30, 110          Fund IRR     = about 10.8%
Market-adjusted flows  : -87.22, -77.87, 0, 37.62, 110 Direct Alpha = about -3.4%

The fund produced a positive IRR of roughly 10.8%, but its Direct Alpha is roughly -3.4%. On the workbook's reading, the market over the same dates returned around 10.8% + 3.4% = 14.2%.

This agrees with the fund's KS-PME of 0.89: below 1 on the ratio measure, negative on the rate measure. A distributor who quotes only the 10.8% IRR is telling Ms Deshpande, the investor, a true number that answers the wrong question.

Chapter 6 (Risk and Return — Investor and Fund Perspective) covers Direct Alpha at 6.6.8 using the same data as the KS-PME illustration at 6.6.7, then summarises all the metrics in a two-by-two table. Questions test whether you know which measure is the market-adjusted rate (Direct Alpha) versus the market-adjusted total (KS-PME), and how to read a positive or negative result — including the workbook's own reading that a 35% fund IRR and 10% direct alpha imply a 25% market return.

• Direct Alpha is a rate; KS-PME is a ratio. A KS-PME of 1.38 and a Direct Alpha of 10% are two expressions of the same outperformance in the workbook's example.
• The IRR is run on the compounded flows, not on the raw flows. The raw flows give the fund IRR (35%); the compounded ones give the alpha (10%).
• Zero, not 1, is the dividing line for Direct Alpha. For KS-PME the dividing line is 1.
• A positive fund IRR can coexist with a negative Direct Alpha — the fund made money but less than the index would have.
• The market used is a listed-market index. Do not substitute the hurdle rate or the investor's opportunity cost; those belong to hurdle and MIRR calculations respectively.
• The workbook's "market IRR = fund IRR − direct alpha" is its own reading of the illustration; answer in those terms when asked.