The Curious Case Of Missing Alpha

In the equity markets, what you see is not necessarily what you get. If the returns are high, then we assume ‘All is Well’ and when at a low we start finding reasons to worry. However, returns can be like the proverbial iceberg. They often conceal a lot more than what they reveal. It is for this reason that returns should not always be taken at face value. Instead, they warrant a deeper and unbiased analysis which can often reveal interesting insights.

The year of anomalies

2018 was a year of anomalies. On the face of it, Nifty 50 generated a slightly positive return while the overall broader markets (particularly the mid and small cap stocks) struggled to finally close 2018 in the negative zone. While some of the large global indices gave negative returns, Nifty 50 gave a positive return. Yet, merely looking at the headline number might be misleading. The headline returns of Nifty 50 masked the entire negativity in the market. The average stock  returns of none of the indices was positive. Most investors saw their portfolios under-perform Nifty 50 due to this reason.

The average stock return of the constituents of Nifty in 2018 provided a more accurate picture and underscored the kind of divergence the market is witnessing. The return distribution of these indices provided a clearer picture of the kind of correction several of these stocks witnessed. The Nifty 500, Nifty mid cap 100 and the Nifty small cap 100 had a high percentage of stocks which provided returns below 20 per cent. The mayhem was not restricted to the mid and small caps alone. More than 50 per cent stocks in the Nifty 50 gave negative returns as well. Even within Nifty 50, there have been only a handful of stocks that have performed well from the start of 2018. Since most of these stocks have a high weightage, the overall headline returns of the Nifty 50 do not portray the actual pain in the market. Clearly, alpha, which is a measure of an asset’s investment returns as compared to risk adjusted expected return, eluded asset and investment managers in the year 2018. This divergence has continued in the first three months of 2019.

Alpha is always there for the taking

2019 is going to be a year of selection. Whether it is the choice of asset class, the investment vehicle or the choice of sector or stocks, investors need to be more circumspect and discerning. Markets regularly offer pockets of opportunities that investors can leverage to generate alpha. Investment decisions should be tethered to the following:

Invest in quality

Quality has always stood the test of time and should be a primary selection criterion. When looking to invest in stocks, always look at the quality of the management. Understand whether they have been honest and consistent with their communication. Also, look for management that has consistently delivered on their commitments or has offered reasonable explanations for any deviation. When looking to invest in funds, among other things, pay attention to the quality of the fund manager. Assess his track record and whether he has consistently been delivering top quartile returns while staying true to the fund mandate.

Avoid valuation traps

If it is too good to be true then it probably is not true. Often stocks trade at compelling valuations that attract investor’s interest. However, investors must make an effort to understand why the stock is trading at a low valuation. It is possible that the health of the company warrants a low valuation. Stocks must be assessed from a holistic perspective and should incorporate future growth prospects as well. Always remember that caveat emptor applies to the equity markets as well.

Generating alpha can be a challenging task in any market environment. However, disciplined investors who carefully analyse investment opportunities can generate alpha better.

The author is Senior Managing Partner and CIO, IIFL Wealth Management