We recently noticed a lot of queries around returns of smallcases – how exactly are they calculated, do they include backtested results, why are actual returns different from shown, etc. The high historical returns of some smallcases especially – like the 44% CAGR of the Magic Formula smallcase, for example – have left many wondering how exactly this is achieved.
While we’ve made these details very transparent on different sections of our website, we thought it would be best to address all these in one post – so let’s take a deep dive into smallcase returns, and the Magic Formula smallcase in particular.
Do shown returns include backtested results?
Yes – for most smallcases, returns include a backtest period. Why? Because the backtested model not only gives us a sense-check & conviction in our methodology, the longer track-record also provides investors a better idea of the portfolio performance across different time periods rather than just a 1-2 year track record.
Only for very limited smallcases, like the Insurance Tracker, the returns don’t include backtests because it wasn’t possible to backtest the strategy beyond a certain point in time due to limited availability of companies/data.
Backtesting is important for any investing strategy, but especially for systematic rules-based ones (like the Magic Formula) to see if the rules remain valid & lead to the desired results in various market conditions.
For the Magic Formula smallcase, the research team first adapted Joel Greenblatt’s initial strategy for the Indian markets – we ran check to ensure all stocks in the chosen universe are liquid & not a large share of promoter’s holdings is pledged. Once the model criteria was established, the strategy was backtested, the results of which are included in the performance shown on the platform.
Accounting for Biases
There are two very important aspects of backtesting of any investment strategies:
- Producing the backtest results without any bias to check how slightly different strategies perform in different periods
- Keeping the criteria same after launch to check/ensure the strategy is working as intended
Once the criteria is set, we start the backtest from the defined inception date (in this case, March 2014).
The stocks included in the initial portfolio would be the ones that meet this criteria. If at any point during subsequent rebalances the stocks stop meeting the criteria, they are replaced with others that meet the criteria.
When conducting backtests, we ensure the stock selection is only based on the information that was actually present in the particular backtesting period.
As such, the process doesn’t pick & choose stocks that did well in hindsight – but instead picks stocks that meet the selection criteria at that point in time, irrespective of how they performed later on.
Why is March 2014 selected as the Backtest Date?
While smallcases officially launched with Zerodha, our first broker partner, in July 2016, work had already started many months beforehand – mainly around building the platform & constructing the various portfolios.
By March 2016, our research team (primarily consisting of folks who had studied at IIT Kharagpur and gone on to design investment strategies for institutions at Nomura) had already identified a few themes and strategies. The results looked very promising – but we also had to ensure they were robust. That means checking the model strategy works in different conditions & largely remains unaffected by outliers.
It’s generally recommended that backtests on financial data (e.g. stock prices) go back at least 8 quarters, to ensure a wide variety of market conditions is captured. For some smallcases, we had available data/companies going back many years, but not for most. To ensure consistent backtests across all smallcases, we decided to only go back 2 years for all smallcases being launched then – and hence the chosen date of March 2014.
How are the returns this high?
The Magic Formula smallcase has consistently been amongst the top performing smallcases since we launched in July 2016, with an impressive CAGR of 44%.
Historical returns have been this high for one simple reason: The smallcase has a mix of large, mid, and smallcap stocks, but tilted more towards small and midcap stocks. The midcap & smallcap segments did especially well after the markets entered a solid bull-run late 2013 onwards, mainly due to the anticipation of Narendra Modi’s BJP coming to power.
Not surprisingly, Joel Greenblatt’s track record at Gotham Capital from using this strategy was ~40% CAGR over the 20+ years between 1985 to 2006.
Why are my returns different?
It’s likely that your returns from your invested smallcase are different from the returns shown for that smallcase on the platform. There are few reasons for that:
- Different Entry/Exits: Returns are calculated from the investment date. Since different people have invested in this smallcase on different dates, their returns have varied accordingly. For example, seeing the table/charts below, we can see how the returns would have varied for investors who invested/exited this smallcase on different dates
- Rebalancing: The historical returns shown for any smallcase assume the portfolio was rebalanced exactly as & when suggested by the model. Individual investors who either don’t apply rebalance updates or apply them later on, are likely to notice variation in returns
- Backtest: As mentioned earlier, the historical returns shown for most smallcases include a backtest period. This is true for the Magic Formula smallcase as well. This only has an impact when looking at returns involving time periods going prior to 13th July 2016.
As a result of these reasons, investors in the Magic Formula (and other) smallcase have had all kinds of actual returns that are quite different from the one seen on the platform. Many investors who either went in early or post market crashes have experienced phenomenal returns that’s even higher than the shown amount.
On the other hand, many investors who bought this smallcase during recent few months have seen their investment drop in value as the midcap/smallcap segments took a beating. While this is certainly not a nice place to be, we urge all investors to take a longer-term view.
In fact, Magic Formula creator Joel Greenblatt himself admits that it won’t always work in all types of market conditions – however he believes that investment is about realizing the best approach & sticking to it in good and bad times.
This can often be especially difficult in bad times – but transparency always helps. We believe in transparency as much as anyone, because after all, we’re investors first ourselves. Which is why we’re putting the entire historical composition of the Magic Formula smallcase here for anyone to cross-verify the returns, if they wish to.
But ultimately, remember that not every smallcase is suitable for every kind of investor. The Magic Formula smallcase follows an aggressive return-seeking strategy, and as such is a high-risk/high-return portfolio that can experience periods of volatility – if you are a potential or an existing investor, please factor this in your investment decision, in case you haven’t already.
And if you have any feedback or suggestions on how we can help you with this decision-making process, do write to us firstname.lastname@example.org.