A lot of newcomers to markets (and capital4) question the need for measuring analyst performance on the basis of NIFTY outperformance (Excess Returns) and wonder why 'Absolute Returns' are not sufficient. Agreed, it does lead to a lot of confusion...but then there are strong reasons for using 'outperformance' as an indicator of performance.
First, the basics. Outperformance (or Excess Return) is nothing but the returns a stock has delivered in a particular period MINUS the returns delivered by a benchmark index (like the NIFTY) in the same period.
Example: Mr.Iyer recommends XYZ company's stock at Rs. 200 on the 21st of June when the NIFTY was at 5350. Today (2nd Sep), the market price of XYZ is Rs.250 today (and the NIFTY is at 5495). The Absolute Return made by Mr. Iyer on XYZ is 25.0% (50 divided by 200) and the Absolute Return on the NIFTY in the corresponding period is 2.7% (145 divided by 5350). Hence the Excess Return achieved by Mr.Iyer on XYZ for this period is 22.3%.
Why is this important?
1) 'Even a monkey...' argument: If a passive investor - somebody with no time to follow the markets or no idea of the markets were to invest in stocks, his/her simplest strategy would be to invest in the NIFTY. Of course, one can only trade NIFTY futures, but you could also invest in the NIFTY using Exchange traded funds like the Nifty BeES. Basically, 'even a monkey' (someone who does it blindly) can invest in the NIFTY. So an intelligent, informed investor is expected to AT LEAST BEAT THE INDEX.
2) The 'time period' problem: When we measure investor performance (more importantly their ability to pick winning stocks) over different periods of time, we need a benchmark to be able to compare them properly. For example, my friend Vishal started investing in early 2008 (oh my God!) and his Total returns in the last 2y 8m years thus far has been 20% (6.8% annualized). In the same period, the NIFTY has lost 10.6% (-4% annualized). Hence his excess return over the last 2.75 years has been 10.8% p.a. Now, I started investing in March 2009 and am currently up 100% on my portfolio (58.7% annualized) return. In the meantime, the NIFTY has returned 105.6% (61.6% annualized) and hence my Excess Return is -2.9%.
Now, the best way to compare our stock picking skills is to measure our outperformance over the NIFTY - i.e, the fact that Vishal entered the markets at a bad time is a matter of poor top-level entry-exit strategy...but definitely not because of his stock picking skills. This is a very important criteria while measuring the acumen of fund managers and analysts - WE NEED TO FIRST UNDERSTAND WHAT THEY CLAIM TO BE. An equity fund manager typically raises money on the basis of his stock picking skills - market entry would be function of when he decides to raise capital!
3) Staying away from snake-oil salesmen: The world (and especially India) is full of websites and 'analysts' whose basic pitch sound like - "Pay us 600 per month and we will give you 6 intra-day calls and 6 weekly long-term calls". Many of them would also show you a headline number - 80% typical return in last 1.5 years! Well, beware of such charlatans. A quick Excess Return check will show you that even a monkey could have done better by investing in a NIFTY ETF. Very few such 'analysts' and websites actually have the honesty/guts to put out their Excess Returns. Most people fall for such schemes to make a quick buck - beware, you may do well in a good year but could get wiped out when broader market also falls.
BOTTOMLINE: EXCESS RETURNS IS EXTREMELY IMPORTANT IN JUDGING ANALYSTS' STOCK PICKING SKILLS.
Which is why, at capital4.com, we measure the excess returns of each stock pick made by all our 30,000-odd members. Without sounding pompus (of course!), the ethical part of investing is very important for us. More on that another day!
First, the basics. Outperformance (or Excess Return) is nothing but the returns a stock has delivered in a particular period MINUS the returns delivered by a benchmark index (like the NIFTY) in the same period.
Example: Mr.Iyer recommends XYZ company's stock at Rs. 200 on the 21st of June when the NIFTY was at 5350. Today (2nd Sep), the market price of XYZ is Rs.250 today (and the NIFTY is at 5495). The Absolute Return made by Mr. Iyer on XYZ is 25.0% (50 divided by 200) and the Absolute Return on the NIFTY in the corresponding period is 2.7% (145 divided by 5350). Hence the Excess Return achieved by Mr.Iyer on XYZ for this period is 22.3%.
Why is this important?
1) 'Even a monkey...' argument: If a passive investor - somebody with no time to follow the markets or no idea of the markets were to invest in stocks, his/her simplest strategy would be to invest in the NIFTY. Of course, one can only trade NIFTY futures, but you could also invest in the NIFTY using Exchange traded funds like the Nifty BeES. Basically, 'even a monkey' (someone who does it blindly) can invest in the NIFTY. So an intelligent, informed investor is expected to AT LEAST BEAT THE INDEX.
2) The 'time period' problem: When we measure investor performance (more importantly their ability to pick winning stocks) over different periods of time, we need a benchmark to be able to compare them properly. For example, my friend Vishal started investing in early 2008 (oh my God!) and his Total returns in the last 2y 8m years thus far has been 20% (6.8% annualized). In the same period, the NIFTY has lost 10.6% (-4% annualized). Hence his excess return over the last 2.75 years has been 10.8% p.a. Now, I started investing in March 2009 and am currently up 100% on my portfolio (58.7% annualized) return. In the meantime, the NIFTY has returned 105.6% (61.6% annualized) and hence my Excess Return is -2.9%.
Now, the best way to compare our stock picking skills is to measure our outperformance over the NIFTY - i.e, the fact that Vishal entered the markets at a bad time is a matter of poor top-level entry-exit strategy...but definitely not because of his stock picking skills. This is a very important criteria while measuring the acumen of fund managers and analysts - WE NEED TO FIRST UNDERSTAND WHAT THEY CLAIM TO BE. An equity fund manager typically raises money on the basis of his stock picking skills - market entry would be function of when he decides to raise capital!
3) Staying away from snake-oil salesmen: The world (and especially India) is full of websites and 'analysts' whose basic pitch sound like - "Pay us 600 per month and we will give you 6 intra-day calls and 6 weekly long-term calls". Many of them would also show you a headline number - 80% typical return in last 1.5 years! Well, beware of such charlatans. A quick Excess Return check will show you that even a monkey could have done better by investing in a NIFTY ETF. Very few such 'analysts' and websites actually have the honesty/guts to put out their Excess Returns. Most people fall for such schemes to make a quick buck - beware, you may do well in a good year but could get wiped out when broader market also falls.
BOTTOMLINE: EXCESS RETURNS IS EXTREMELY IMPORTANT IN JUDGING ANALYSTS' STOCK PICKING SKILLS.
Which is why, at capital4.com, we measure the excess returns of each stock pick made by all our 30,000-odd members. Without sounding pompus (of course!), the ethical part of investing is very important for us. More on that another day!
