Learning outcomes. After watching this video, you will be able to understand the importance of benchmarking. Welcome back. In this session, we're going to talk about benchmarking. Benchmarking is a prerequisite before you start a fund. Even if you are investing your own money, even if you are investing money of your friends and family, it's absolutely necessary that you determine a benchmark. Otherwise, there is no way you can measure your performance. A minus five percent on its own, doesn't tell you whether you have done, you know good or bad. Imagine, in the year 2008, if you were down minus five percent, you would have been one of the top performing funds or investors you know in that year. Whereas in the subsequent year, when the markets rallied, even if you're down, say, 20 percent or 15 percent, you may not be near top; you may be at the bottom or in the middle. So it's really important that, beforehand, you determine a benchmark. The importance goes up several notches higher if you're managing somebody else's money. Remember, this is not typical investor psychology which has been documented over and over again in different parts of the world. When the market goes up, generally, people don't care about how we have done with respect to benchmark. If you're down 40 percent return, if you made 40 percent, even if the index says even 50 percent, investors will be fine with you, because, at the end of the day, they have made 40 percent. The importance of benchmark you know is higher when the market goes down. Suppose you have made minus 20, and even if the benchmark is down minus 40, unless you really go and communicate this to investors, they will think that you have done very badly. You may be thinking that, "In the market has gone up minus 40; I'm down on the minus 20 so I've done better," but, generally, retail investors consider this as a bad performance. They don't care about the benchmarks. So it's really important you communicate this to your investors that your performance has to be evaluated with respect to a benchmark. Now what kind of an index you should choose as benchmark? Can you just choose a broad umbrella index like Dow Jones or S&P 500? The answer is no. It depends on what your strategy is. What is the composition of stocks that you have? Suppose, let's take,you know the growth strategy that we discussed. Do you remember the growth strategy that we spoke about? Yes, the G score strategy. Now here, by definition we'll be picking stocks which are likely to grow and if you see the components of the strategy, we are looking at research and development, investment in research and development, investments , capital expenditure, firms which are making all these; these are in growth industries. Now, if you compare these stocks to a broad index which comprises of all kinds of stocks, then you will not be making an apples to apples comparison. Things may be fine when the market goes up, in fact, these growth stocks tend to be high beta stocks. So when the market goes up, they may outperform the market but this will haunt you when the market goes down. Suppose you have for a G score long only strategy, remember you chose a long only strategy and used G score. And you've determined the broad market index as your benchmark. And the market index falls by 10 percent. Now, for no fault of yours, even if you have done very well, the G score stock if you're a long only, may fall 13 percent. In fact, if you consider the beta of those of stocks, that maybe two. So, ideally they should have fallen 20 percent but your strategy has fallen only 13 percent, you've actually done well. But after the fact if you're going explain it to an investor, nobody will buy your argument. You cannot go back and say having determine a broad index as your benchmark, you cannot go back to the investor and say, "I have invested in growth stocks. These are hybrid, they should have gone down 20 percent but actually it's gone down only 13 percent. We outperformed by seven percent." No one will buy this argument. It's important therefore, that you specify a benchmark ex-ante. What do we mean by ex-ante? Before the fact, not after the fact. So for a growth oriented strategy, right benchmark will be an index comprising of growth stocks. Identify in your respective market and index which comprises of growth stocks and make it a benchmark for a growth strategy. Similarly, if we're trading on a value strategy, what is wrong with having a broad index as a benchmark? These value stocks are as we've discussed. Again, when some of the value stocks, if you are falling Petroski, they are small stocks and they can lose a lot of money when the market falls. Again, if you compare it with the well-established, mature large firms, when the market falls you may not be able to explain this to investors why you are under performing a broad index. There also, you should select an appropriate value type index as a benchmark. So for long only, the problem is not that difficult it's straightforward. Now, what when you do in your long short? You know the most strategies that we discussed in the last three four modules are long shorts, long short strategies. That means, you buy something sell something. What you do in you know price earnings announcement drifts, you look at firms which are well performed, go long on them, look at firms that have under-performed, go short on them. That's a long short. Right? Similarly, what do you do in a accrual strategy? firms with higher accruals, you short them, firms with higher accruals, you go long on them. So, most of the strategies in fact, almost all the strategies that we discussed are long shot strategies. Of course, you can just trade with one leg of it, but the academic papers actually test these strategies using a long short approach. Now, in a long short approach actually theoretically, what you've invested is zero. Just think about it, you sold the stock for 100 bought something else for another 100, and what yo invest in is zero or very close to zero, subject to rounding. Now, how do you measure performance here? Now as we discussed in one of the modules, that for these kind of contracts, where you're trading you know going short or going long, you'll have to invest in something known as margin. So that margin that you have invest with your broker, that can become a base. So you can calculate return based on the margin. But you have to be really really careful here. Assume, the margin required in your market is like 15 percent. So you go long on a stock, go short on a stock. Now we have 30 percent you've invested just, you know,15 percent of the total investment made. Now, if you make five percent on the gross value of the stock if you only make just five percent say, your long has gone up two percent and your shot fell three percent, so you make five percent. Now, on the gross contract you're low to five percent since you've invested just 15 percent in margin, your actual return will turn out to be several times more on the margin investor. It's not-you do not do five percent six times more than five percent Similarly when you lose, if you lose five percent, that loss will be several times. So, this is something that when you measure based on margin, you should tell your investors that the fluctuations are going to be huge. So, the ideal benchmark for a long shot strategy is on the margin that you invest, because this margin if in your country your margin can be invested in say, safe government bonds, the risk free rates that you make is something- is the benchmark. You should make at least a risk free rate. Your market index is not the benchmark. So it's not right to compare a long short strategy with the market index. In fact, you will be tempted to do this on several occasions. Imagine you started along short strategy, and the market collapsed. Now, because you have longs as well as shorts, you may still be positive, or you will definitely not fall as much as the market because your shorts will make money when the market falls. Right? Suppose, during 2008, beginning of 2008 you had short at middle of 2008 when the collapse happened. You started this strategy, long shot strategy. Now, what will happen is the market may fall 50 percent because you have shorts, your fund will not fall as much. Now at this time, you'll be tempted to claim that you've outperformed the index, whatever broad index by a massive margin. Which is true but not the entire story because the index is long only, index is not long short. It's only your trading strategy is long shorts. So you're comparing a long short strategy with the index. Now what's wrong with this? The problem is when the market rebounds 50 percent, maybe next year, you will not be able to keep pace with the market. You may be down. Because why? When the market rebounds, in fact we have done this momentum crashes if you remember. Momentum crashes paper exactly says this; When the market recovers, the losers, you know come back viciously. They all perform,you know significantly. So, if you're short on let's say, you are doing a momentum strategy, long short, you're long gone past winners short on losers. Now, losers can double, triple or four times, because of the optionality, you can go back to that class where we talk about momentum crashes or you can read Daniel Grant's paper, as well. So, if these stocks come up when the market recovers, then the benchmark may be giving 50 percent. You are the-- and you may be at five percent minus five percent minus 10 percent, you will be cutting a soaring figure at that time. So, it's very important not to compare our long short strategy with the index. So if we're doing a long short strategy, your ideal benchmark is margin and risk free return on the margin. Anything above risk free return on the margin if you make, that is a positive. It's not the market index, you should keep this in mind. So, to summarize, if you're only doing long only, then figure out an appropriate index which comprises of the kind of stocks that you will invest in the strategy and tools that indexes the benchmark. If you're going long short, then the best way that I can think of is, margin risk free rate on the margin. Just choose risk free rate on the margin and anything more than risk free rate, you can claim as outperformance..
