Benchmarking it right

Wikipedia defines Benchmarking as the process of comparing one’s business processes and performance metrics to industry bests or best practices from other companies. Unless one compares and contrasts, one never knows where one is placed relatively speaking.

But the key point to note is that Benchmark works only if done correctly. As a joke / moral goes (Cartoon below), if you were to select a bunch of animals and benchmark them against a single target, you aren’t benchmarking it right.

When it comes to investing, Benchmarking is important since it enables you to get a much better perspective on whether you are getting it right or wrong. If your returns on investments over a period of time cannot even match returns generated by the Index, does it really make sense to keep trying by spending valuable time or whether will you be better off by just buying a cheap ETF that tracks the Index and be done with that?

Mutual Fund managers / PMS fund managers and even Robo Advisors love to tell you how good their picks were and how they have beaten the Index by a comfortable margin. But given the fact that there is plenty of evidence on the other side of the Atlantic about how very few fund managers are able to beat the Index, it makes one question what is missing out here.

The question we need to ask is, Are our fund managers way better in ability to invest than their counterparts in say the United States? After all, if fund manager after fund manager cannot beat the Index on a sustained and continuous basis (heck, even Warren Buffett changed how he measured performance of BRK vs the S&P 500), how is that our fund managers are able to do with such ease.

One reason could be that our Indices are still evolving and hence a lot of quality stuff are left out while including a lot of low quality stocks which end up ensuing that if you replace all the bad apples in the Index and add a few good apples, probability of your returns exceeding the Index is pretty high.

Lets take the broadest index out there, the Nifty 500 and review its list of stocks. Here is a list of 10 of them,

GTL Infrastructure Ltd.
Alok Industries Ltd.
Gammon Infrastructure Projects Ltd.
Unitech Ltd.
Jaiprakash Power Ventures Ltd.
Lanco Infratech Ltd.
GVK Power & Infrastructures Ltd.
IVRCL Ltd.
Usha Martin Ltd.
Jaiprakash Associates Ltd.

What is common in every one of them? Other than that they are all embroiled in debt of the nature that they cannot possibly repay in full, literally everyone has gone through Corporate Debt Restructuring and unless one has been under a rock, the probability is that they shall all fail. Yet, these gems form part of the largest index, stocks that theoretically are penny stocks and have no business getting traded, let alone being part of a index.

Of course, the weight of these are small, but do note that if you can identify stocks that like above and make no allocation, you will beat if you buy the rest in the proportion they are weighted. Its as simple as that. You don’t even have to go out and try and identify stocks out side that are way better than these junks and you shall still be a winner.

A secondary way to beat / or showcase beating the Index is by comparing with the wrong set. Literally everyone loves to compare himself with Nifty 50, but is Nifty 50 really the correct benchmark if you are investing in all kinds of small cap and have a large turnover ratio?

The thing with static indices is that they are always Long – no matter what and even if you can reduce exposure a bit and if those days are bad, you can turn out to be a winner. You will argue of course that how the hell does one know about bad days in advance and for that, I shall post this tweet from a twitter friend who posted it recently.

80% of the worst daily return days happened when Nifty was < 200 MA..same if we exclude 2008 pic.twitter.com/kfGSrpT6mv

— karanb (@karanb_k) January 26, 2016

80% of those bad days had a single independent factor that is known before the bad day has taken place. Now, lets go back the question, How difficult to reduce allocation when Nifty is below the 200 day average? We aren’t talking about shorts or even selling in full. All I am talking about is reducing exposure of equity to 80% and keeping the 20% in cash. What probability do you think you have when it comes to beating Nifty. Remember, we are not even adding stocks from outside, its all a question of allocation.

I am not sure how many are aware of a Index NSE has (and in recent past, NSE has started way more indices than your fingers can count) that goes by the name Nifty Alpha 50. To read more about that Index, please do download this document (Nifty Alpha 50).

To me, the biggest disappointment is that while NSE keeps introducing Index after Index, we really have no way to invest / trade in the same. One hopes that someone with the powers that be shall take notice of this and do something to remove the anomaly. But first, lets compare the performance of the Index vs our Nifty 50

In all years when Nifty was +ve, save for 2013, Nifty Alpha 50 has beaten it. While 2008 showcased how wrong thing can go, 2015 was a case of Alpha trumping even as Nifty closed the year with -ve returns.

If you feel that I am comparing wrong and should be comparing against the Nifty 500, let me show you those numbers as well

Not too different, ain’t it? So, how many funds / advisers have you found bechmarking themselves to the Alpha Index?

Another way to beat benchmarks is to select the period that works best to showcase better returns. A famous fund manager plastered the town with 100% returns over the period of 1 year. But this wasn’t a financial year, it was just from the date he accomplished that number to 1 year prior. The financial year number was 35% (IIRC) below the 100% mark, but he had achieved infamy by then and why bother with these small details.

Advisers (who just provide advise for a fee) who beat the Indices generally do no even bother with small things such as slippage / market limits (as to how many stocks you could have possibly bought at that price) among others. Why let data interfere with the selling they would say.

Benchmarking is a important process and regardless of how others do, its important that you understand the biases and fallacies that can accompany one. After all, its your money everyone is after.