July 2021 Newsletter – Measuring Performance
Do-it-yourself (DIY) investing is all the rage. NSE data reports that retail now commands 45% of the total turnover on NSE
Turnover doesn’t equal ownership. Retail ownership has moved slightly higher versus its lows but even if the indirect ownership via Mutual Funds are included, it’s still very much below its all time highs.
One explanation for the fall in direct ownership over time would be the rise and growth in assets at Mutual Funds. Retail has slowly shifted away from owning Individual Stocks to owning Mutual Funds.
From both the tax point of view as well as the cost structure, owning a fund is generally cheaper. This is more so for the investor who looks at investing a large part of his net worth in stocks.
Indian Markets are very illiquid. What this has meant is that the majority of funds concentrate on the top 400 stocks at the most even though NSE alone sees daily trading in more than 1700 stocks. On the BSE, there are another couple of thousand stocks that are not even part of the ecosystem of most investors let alone Institutions
The above chart plots the number of new demat accounts that have been opened.
Now, you can look at it from both the bullish angle as well as the bearish. The bearish angle will claim that the retail rushing in is a clear signature of the top. After all, isn’t there a saying,
“Fools rush in where angels fear to tread”
The proverb is also apt given that despite all the positive news we keep hearing, FII’s have been sellers in the recent past.
I look at the data from the bullish angle. My view is that while there will always be excesses, the data of the past cannot be directly compared to the data of today. Context is the key.
For a long time stock market investing was equalized with gambling. This was due to many factors including very low compliance and rampant frauds – from the broker upwards. In recent years, compliance has really improved a lot.
While we even today have broker defaults, the hit for the investor is constrained thanks to better regulations and the backstop of the exchange guarantee funds.
Access to knowledge has improved by leaps and bounds mostly due to technology. This has meant a better understanding of the markets and how they operate in the long run. This doesn’t mean that investors as a whole will make money.
Rather, I feel that the Pareto Principle is as relevant here as it is elsewhere. 80% of the money will be made by 20% of investors. A study in the US shows that all the wealth ever made in the US Markets has been just 4% of stocks.
The entire report is worth reading, but here is the key conclusion
While the overall U.S. stock market has handily outperformed Treasury bills in the long run, most individual common stocks have not. Of the nearly 26,000 common stocks that have appeared on CRSP from 1926 to 2016, less than half generated a positive lifetime buy-and-hold return (inclusive of reinvested dividends), and only 42.6% have a lifetime buy-and-hold return greater than the one-month Treasury bill over the same time interval.
The positive performance of the overall market is attributable to large returns generated by relatively few stocks. Rates of underperformance are highest for small capitalization stocks and, as would be anticipated based on the evidence in Fama and French (2004), for stocks that have entered the database in recent decades.
When stated in terms of lifetime dollar wealth creation to shareholders in aggregate, approximately one third of one percent of the firms that issued common stocks contained in the CRSP database account for half of the net stock market gains, and slightly more than four percent of the firms account for all of the net stock market gains. The other ninety six percent of firms that issued stock collectively matched one-month Treasury bill returns over their lifetimes.
With odds as unfavorable as these, it’s not surprising that long term wealth creation by Do-it-yourself investors is a rarity. Yes, everyone has that stock that one bought at a low level and held till it was a multibagger, there are exceptional years such as the one we are presently in. But one swallow doesn’t make a summer
One of the most surprising things is the fact that very few investors actually take the trouble to measure their performance.
Sharmaji ka Beta is the benchmark for most parents. If that boy can do it, why can’t you achieve the same. This is also called Cross Sectional Momentum. The comparison is never against self but against the rest of the colony / class.
Yet when it comes to one’s own performance, there is very little clarity as to how we are doing. Measuring performance is akin to keeping a dairy. It helps understand how we are performing and compare and contrast with the opportunities that are available elsewhere.
Measuring helps understand whether we are doing the right thing or not. When I used to be a broker, I measured the performance of myself as well as a few friends who also happened to be clients. This helped in understanding how I was doing in the scheme of things and where I could do better.
In Measure what Matters by John Doerr, the author expands on OKR’s (which stand for Objectives, Key & Results). Once you get them right, all you then need is a checklist to ensure that execution is as good as the process.
Since I started investing based on the Momentum factor, I have kept detailed records not just of the transactions but the ranks the stocks were during the time of entry / exits. This is helpful in removing chinks that are part of my system.
The way to identify the chinks though comes with Performance Attribution and Performance Measurement.
In the 2017 bull run, I remember a fund manager who ran a small cap fund but compared his returns to the large cap index. This turned out to be a good way to sell, but reminded me of the famous quote by Richard Feynman
“The first principle is that you must not fool yourself, and you are the easiest person to fool”
What is the appropriate benchmark for a DIY Momentum you may ask.
I believe that comparing an active strategy such as Momentum with a passive index is doing a disservice. Yes, the outperformance is awesome, but the products are as different as chalk and cheese – this more so for the Multicap strategy.
Momentum has been awesome since April 2020, but if I were to plot the NAV of my own personal performance with Nifty Smallcap 250 Index and the Nifty Smallcap 100 Index, this is how it would look like
The above chart is useful to understand where the performance is being driven by. What this also provides is a framework of the risk such a high Beta strategy will face if the markets were to start rolling over.
Now to check against some Momentum Indices – primarily Nifty Alpha 50 and Nifty 200 Momentum 30
While Nifty Alpha 50 is not an investable index owing to no funds, it’s a pure Momentum strategy and hence a worthwhile opponent to compare against. Nifty 200 Momentum 30 on the other hand is more like a Nifty Plus strategy and not a pure momentum one given how lagging its rebalances are, but since it’s possible to invest, it’s another one which can be compared against.
Do note that a straightforward comparison in a way is wrong too. Unlike DIY, Mutual Funds gains are tax sheltered and in the long run that can really mean a huge world of difference. Not to mention the advantage of Buy and Forget in the world of Mutual Fund while having to be alert and tinker with the portfolio every week or month as the rebalance frequency tends to be.
The other day, I tweeted this
In my 25 years I have spent in the markets, I have seen a lot of people come and go. Some had exceptionally good returns for a while but mostly lost their way. I wish & try to meet people who are exceptions to that rule.
For a fund manager, beating the market is what he gets paid for. He can’t have a few lost years and a few great years. Even if the ultimate returns are better than the benchmarks, clients won’t stay {Exceptions alway exist}.
A Momentum or a Value or even a Quality factor will be unlikely to beat the markets every year. This means that one has to have the framework to allow oneself to be beaten by the markets once in a while (or maybe even a bit more).
Finally allocation is more important than returns. Allocation though comes with comfort in the strategy. As a Do it yourself investor, the key is to understand the source of the return and the failure points. It’s that which can help stay sane when the strategy is not working while also not getting hyped up over excess returns in one or two years.
The reason funds managers get rich has to do not only with the leverage provided by assets of the client as also their own confidence in their strategy that allows them to be 100% invested. As a DIY investor, we are our own fund managers. Its up to us to take the steps necessary to make sure that we are on the right path.
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