Can the Index be beaten?
The evidence these days seems to suggest that most funds are unable to beat the simple market cap weighted index. Reasons vary from the high fees that eat into the returns to having different portfolio weights from the Index. We did a detailed analysis when we sat down to modify our long term portfolio offering. Capitalmind Large Cap Portfolio Gets A Major Makeover {Premium}
Bank and Non Banking Financial Companies together currently have a weight of 40% in the Index. This has been the driver of returns for quite a while and within this sector, Private Sector Banks and Institutions command a weight greater than 80%.
Exchange Traded Funds has been making a huge splash in the world of Finance thanks to the strong belief that markets are fast becoming so efficient that it makes zero sense to try and beat it. The biggest advantage for investors is the low fee charged by such ETFs.
ETFs are no magic pill either though. If markets go up 50%, they go up 50%, if they go down 50%, they go down 50% as well. While mimicking sounds excellent, what it also means is that unless you have a good understanding of your own biases, holding onto the investment during the bad times would be way more difficult in reality.
Mutual Funds are required to benchmark their performance against the category index they claim to use as the Universe. For Large cap funds, this has essentially meant using Nifty 50 / Sensex 30 or Nifty 100 as their Benchmarks.
Recent SEBI guidelines have meant that large cap funds now need to hold a minimum of 80% of the stocks from within the Index. With weight of financials being very high, funds which have differed have suffered by under-performing big time.
A one or two year bad performance impacts not just those years but the total returns of the past as well as Alpha generated over years can go down the drain.
This is not a phenomenon unique to India as country after country has been seeing passive out-performing active investing via mutual funds.
But does this mean, Alpha is Dead and Passive is the only way out?
What seems to be the case is: Alpha even in the Large Cap universe is available.
Alpha in investing is the difference between the benchmark and the portfolio. If your portfolio which tracks say Nifty 50 is up 25% in a year when Nifty 50 is up 20%, this means you have generated 5% of Alpha.
Alpha is generated by two ways – selecting the same stocks and differing in weights – also called Smart Beta Investing or selecting a smaller subset of stocks and once again with differing weights.
The first method is fairly well known. Nifty 50 Equal Weighted Index for example is an Index that has the same 50 stocks and yet differs in weight compared to Nifty 50 Market Cap Weighted Index.
The second method is what most funds claim to practice. Of the 50 stocks, they try to select 20 to 30 stocks with different weights. The selection procedure can be either Quantitative or Qualitative or both.
Missing out on stocks that are the heavy weights in the Index leads can lead to positive alpha if those stocks under-perform the index or negative alpha if those stocks out-perform the Index.
A well known value oriented fund which was earlier a Large Cap fund for example has no allocation to HDFC Bank or Reliance Industries which together command nearly 20% weight in the Index. This has led the fund to under-perform Nifty 50 by a huge margin and one that is not easy to reclaim.
At the beginning of 2001, 70% of the market capitalization of Finland owed to one firm – Nokia. To just match the Index, you would have had to have a 70% weight in your portfolio to Nokia. This after it had fallen quite a bit post the Dot com bust. It would never go back to its high of 2000 ever again. Would you have been comfortable having 70% of your equity exposure in one stock even though you were merely replicating the index?
I took the one less traveled by, And that has made all the difference wrote Robert Frost. Unfortunately in the real world where our performances are measured every-day, taking the road less traveled can be very painful to one’s career.
But as investors, how are we different from the sheep of the world if we too follow the herd rather than making our own paths. Investing is not just about Reward but also about Risks. If the Index falls 50% tomorrow, should your portfolio fall 50% is the question that remains unanswered.
Recently, the Argentinian Index fell 48% in a single day over President Mauricio Macri’s wider-than-expected margin of defeat in primary elections Sunday by his center-left rival, Alberto Fernández. Reasons don’t really matter, what matters is that if you had invested in the Index, you were 50% poorer by the end of the day than one when you started off with.
Yet, we miss the forest for the trees. The Index post the fall is still positive for the year. That is the kind of move it had before all hell broke loose. Think about a fund manager who avoided the whole move – Zero returns even as Index doubled. Do you think investors would have poured more money or pulled out their monies?
So, let’s come back to the question we started off with – can we out-perform the Indian Indices while at the same time not having similar kind of draw-downs. Nifty Next 50 for example fell 81% from its peak in 2001 and 73% from its highs in 2008.
Both these draw-downs didn’t happen in a day but if you were a long term investor in the index, you had to take the hits. While it’s one of the best performing index over any 10 year period, this amount of pain is not entirely bearable unless you are Rip-Van-Winkle.
What is the alternative if one wishes to stick with large cap stocks. Well, this post is about a method where you could be positioned within the large cap universe, get a decent alpha and yet not see the draw-down of the Index.
At Capitalmind, we run a Multicap Momentum Portfolio. I say Multicap because we don’t limit ourselves to any specific category of stocks. The portfolio while being better than the Indices has a down-side, it suffers from much higher volatility.
We continue to research on ideas that we hope can help us do better in our stock selection and portfolio construction. One such research has been to try and use the same logic we use in our Momentum Portfolios on a Universe of Large Cap Stocks.
Universe
Our Universe of stocks was chosen from NSE with the Top 100 in terms of Market Capitalization being the ones we selected on which we ran our algorithm. Since stocks keep changing over time, we updated the Universe of stocks that are available for us to select from once a year.
Criteria for Entering Stocks
At the end of each quarter, we scan for stock, ranked on Sharpe Ratio. You can get this on our Snap toolkit (https://snap.capitalmind.in/#/sharpe)
We are looking out for stocks that have shown the highest return with relatively low volatility. Since our Universe is the top 100 stocks by market capitalization, we don’t need to worry about liquidity. To ensure that we don’t fall prey to selecting the winners who have survived, the database we used is suvivorship free.
Portfolio Size: Number of Stocks
One of the interesting findings in this whole exercise was that we saw out-performance on all portfolio size from 5 stocks to 30 stocks. But since we are looking at Risk Adjusted Returns, we settled in for 20 stocks which seemed to offer the best mix of Risk and Return.
Portfolio Churn
Momentum is mean reverting on the short term and on the long term. Its only in the middle that it works fantastically well. Our Momentum Portfolios try to minimize on timing luck by churning every month. But with large caps, we found that the differential in returns between monthly churn and quarterly was not much. We hence preferred to look and change the portfolio at the end of every quarter (March, June, September and December).
Here is a comparison chart of the NAV between Monthly rebalance and Quarterly rebalance. Both from a returns point of view and from the draw-down perspective, Quarterly beats Monthly hands down. Better still is the fact that lower number of rebalances mean lower fees and charges that are inevitably part and parcel of active investing.
For the Quarterly, we chose the calendar quarters with rebalancing at the end of March, June, September and December. But what if we chose non calendar quarters, how would that have impacted.
The reason to test that is to see if there is an amount of luck in the rebalancing months we have chosen. While one anticipates returns to be similar, results were pretty different for not only were returns for the other quarters lower, but they also suffered a higher draw-down.
The question is why? Why does calendar quarter works great compared to non calendar quarters? One answer could be the fact that markets discount the future and the short term future includes results.
When we rebalance in March, we aren’t exposed to the volatility surrounding the results of the stocks which are part of our portfolio. But if you are rebalancing at the end of April or May, the impact of results will be seen.
This in others words seems to suggest that the trend is already set before results with the results only pushing the trend deeper. So, stocks where the market anticipates a good result is also have started to show positive trends and hence liable to be picked up by the momentum filter while it works the other way for stocks where market seems to anticipate a weaker or lower than expected result.
Will this trend continue? A million dollar question and one we won’t really know the answers for. Only time will tell whether this holds true or we shall see a mean reversion coming.
Risk and Drawdowns
Let’s look at the draw-down of the 20 Stock Portfolio and compare against Nifty 50 and Nifty Next 50. What do you see?
The blue line is the draw-down, save for one instance in 2006, till 2009, it has a draw-down lower than the main indices. In 2008, while Nifty 50 and Nifty Next 50 saw a maximum draw-down of 59.86 & 72.49% respectively, the Large Cap Momentum Portfolio had a draw-down of 52.83%. Lower, but not that much great.
What is interesting is the behavior of the portfolio during the reversal which saw Nifty go back to the highs of 2008. The portfolio had the worst draw-down all the way up. To understand how this happened, we need to go and look at monthly returns.
Monthly Returns
Listed in the picture below is the monthly returns of the Large Cap Momentum Portfolio.
Like any other strategy, this is a mix of positive months and negative. But without knowing how the broader index had performed, we cannot understand the pro’s and con’s of this strategy. So, here is the table for Alpha from the portfolio (using Nifty 50 returns as the base).
The portfolio has out-performed and generated positive alpha in 9 out of the 15 years. On the monthly front, the portfolio has beaten the Index 57% of the time. Not that great you may think but compounding works wonders on small edges.
But Let’s See the Killer Combo: Nifty 50 + Next 50
But this is on Nifty 50. One of our observation and one that tests backed it up shows that rathe than buying just the Nifty 50, an investor is better off with a combination of Nifty 50 and Nifty Next 50. In fact, at our Capitalmind Wealth PMS, we offer our clients an Index Portfolio where 40% of the weight is in Nifty 50, 40% in Nifty Next 50 and 20% in Nasdaq 100. This we believe offers a better deal. You can read more about it here (The Market Fund)
Would buying the top 20 stocks and rebalancing them on an quarterly basis be able to beat that return? Well, rather than guess, we tested and were surprised by the results.
Large Cap Momentum portfolio had a significant differential in returns (both in terms of positive and negative returns) from 2005 to 2015. But since then, both of them have provided more or less similar returns as can be seen in the 3 year rolling returns chart below.
As can be seen, both are trending very similarly. The difference though is that while Large Cap Momentum has churn, Nifty + Next is a simple buy and hold with minimal re-balancing. The reason behind the similarity of both could be due to the fact that much of the driver of returns for the Indices has come from the top 20%
Of the current Nifty 100 constituents, 45 stocks have negative 3 year rolling returns. On the other hand, current Nifty heavy weights have generated tremendous returns. Reliance 3 yr CAGR is 35%, HDFC Bank chimes in at 20%, TCS at 22% and Infosys at 16%.
Trend Following has a win-loss ratio around 40:60 range. Yet, its immensely useful as a strategy since it combines long-term drift in your favor by compounding it. Momentum Investing is a form of trend following but rather than time series momentum we are basing the strategy on cross sectional momentum.
But if the end result is the same as buying and keeping 2 ETF’s that charge less than 0.10% as expense ratio, is it even worth the time and effort? The pro of Large Cap Momentum historically has come from it seeing a lower draw-down since we go to Cash if not enough stocks are available to choose from versus the Index which takes the whole pain. But active strategies have additional headaches:
- Transaction costs
- Taxes
- and of course, the time you need to execute this (every quarter)
The incredible shift we are seeing into Index and Exchange Traded Funds has meant that active funds have had a hard time meeting their return, let alone beating. Michael Burry, the famed Hedge Fund manager who shorted Housing Bonds via credit default swaps and was featured in the book, “The Big Short” by Michael Lewis believes that in US, Passive Investing is approaching bubble territory. But you cannot fight by shorting and hence he believes it makes sense to be an active investor in the small cap space where impact of passive funds is less.
As fund managers, its hard to accept that a simple rule based system and one that can be followed by paying a seemingly negligible fee can beat the best brains out there. But data doesn’t lie.
Alpha it seems is now confined to the Mid Cap and Small Cap space where efforts add value in terms of better returns.
For everything else, there is the Killer Index ETF.
At Capitalmind, we are mindful of what the data showcases. We run a Advisory service where we offer a Multicap Portfolio which is based on growth and value factors. In addition, we also run a multi-cap Momentum Portfolio. For clients looking at Income through Dividend, we also offer under the same Umbrella a Dividend Yield Portfolio.
In addition, we are SEBI registered Portfolio Management Service company offering Index Portfolio / Multicap Portfolio and Momentum Portfolio at low cost. Do check out more of that at Capitalmind Wealth.
