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Are you running your own mutual fund? Is it doing well?


06 Jul 2021 - Contact Sayan Sircar
6 mins read

When you are investing in stocks directly, are you measuring your performance as a fund manager?

How to benchmark while investing or trading

Table of Contents

Introduction

Direct stock investing (DSI henceforth), whether for short duration (day trading or swing trading) or for long holding period attract many people. DSI is nowadays very easy due to the proliferation of discount brokers, social media experts and overall information availability. Since the market bottom of March 2020, many new investors have come to the market on the back of the bull run that started in April 2020.

The alternative of DSI is investing in equity mutual funds which means that each DSI investor is effectively running their personal mutual fund. Since all mutual funds should be periodically reviewed, how do you review the performance of your personal fund?

This is important because the purpose of investing is to meet a goal and for that, it is important to know if you are doing as well as you should. It is common among investors to say that their investment has got 20% CAGR or 15% XIRR but is that better or worse than a benchmark? This post deals with a simple way to measure the performance of DSI. Once the calculation is done, it is up to the investor to make the rational choice of implementing whichever strategy makes more money consistently.

Costs of DSI

There are multiple costs of investing in stocks directly, some of which are known and measurable while the rest are not.

  • Taxes: Securities Transaction Tax (STT) and Capital Gains Tax
  • Brokerage: This is typically 20-100bps for full-service brokers and zero for discount brokers for delivery. All brokers however charge a certain fee for intra-day trades. Also, some brokers offer a low brokerage plan for intra-day trading that costs a flat fixed fee. This needs to be captured under costs
  • Strategy fees: Some trading strategies (like Smallcase or via Social Media/Email) charge a monthly/quarterly or yearly subscription charge. This needs to be captured against costs for DSI
  • Slippage costs: this happens when a strategy gets updated once markets close (like over the weekend), and it gets executed at a different price when markets open on the next trading day. Another way this cost occurs when the strategy uses fractional shares to calculate the weights and generates a signal but execution happens using integer shares
  • Tax-pass through: Mutual funds do not pass on taxes when they buy/sell stocks but the investor while any selling during DSI will incur long term or short term capital gains taxes

How to measure performance

The premise of measuring the performance of DSI vs. mutual funds is seeing if the profit in DSI after all costs is more than if the money was simply invested in the Nifty index or an equivalent Nifty/Sensex index fund. The choice of the index is not that important since it can be argued that for example DSI in small-cap stocks should be benchmarked against the Small Cap index which is nowadays investible via index funds. However, investing in a Nifty Index fund is the simplest thing any investor can do and is therefore good enough for the choice of the benchmark for DSI.

We will create a replicated portfolio like this. For every trade (buy or sell), we will take the pre-tax price of the trade (market price times shares) and calculate if the money was invested in the Nifty index (or Nifty index fund), and then how many units of the index would have been bought (or sold). The sum of the index units multiplied by the current price of the index shows the amount that would have been there if there was no DSI. Ideally, the investor should do whichever strategy gives higher profits: DSI or Replication consistently.


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Human capital and the best usage of time

Growing wealth depends on both income and investments and is one of the axioms of personal finance. There is an intrinsic limit to the amount of time you can spend per day or week in your primary profession. If you know your hourly wage, and you should like this, you should also be aware that you cannot scale the denominator i.e. hours/day indefinitely. This leads to the concept of increasing human capital, where you are enhancing your skills and knowledge to increase your income - both active income from your profession and passive income from other sources.

Greatest returns come from human capital

If you are investing in stocks directly, either trading and investing, you are spending a good amount of time in that activity trying to get higher returns. You should consider if it will be prudent to divert that time to your profession instead to increase your income to get more capital for investing. Human capital is covered in more detail here: Your human capital, not investment returns, is your biggest wealth creator.

A worked out example

Example of replication portfolio

Here we have two stocks A1 and B1 that have been traded from 2015 to 2017. Brokerage is assumed at 1% of trade value (change it to what applies to you) and capital gains tax is included for sell trades. There is another field called Other costs for any regular costs like subscription or brokerage plan costs. The Nifty value/units columns have the replication values. We take the value of Nifty on that day and calculate the Nifty units bought or sold.

In the example, there is a ₹ 1,000 cost of executing the trading strategy.

As the table shows, profit in the case of holding the Nifty portfolio is ₹ 6,789 while that of the DSI portfolio is ₹ 5,550. This lower alpha (DSI minus Nifty) is made worse by the ₹ 1,000 execution cost so the DSI portfolio is worse off vs. the replication portfolio.

We show these calculations in the Excel sheet here.

If you get a positive alpha figure after costs then that is good news since you are beating the replicated portfolio. If not, you need to decide soon how long you are planning to continue with DSI before switching to mutual funds.

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