Long-short model pays off for India

SELL-SIDE analysts appear to have emerged as a more valuable resource for investors in India than in any other major market. To some observers, structural idiosyncrasies in the nation’s US$5.4 trillion stock market are giving skilled stock-pickers an edge.

A long-short strategy model that involves buying the top quintile of stocks most favoured by analysts in an index of the largest 200 Indian firms, while simultaneously shorting the bottom quintile would have returned 105% over the past decade, data analysed by Bloomberg News shows.

The same market-neutral trade on the S&P 500 Index would have yielded just 14% in this period.

While an unprecedented retail-investing boom and large new listings have seen India’s value double over five years, its market structure is still relatively inefficient and less saturated when compared to developed peers such as the US.

That means stock prices often take longer to reflect underlying fundamentals, creating more opportunities for alpha generation, observers say.

In more mature markets, such mis-pricings are quickly arbitraged away by institutional investors and hedge funds.

Further, short sellers are largely absent in India as the nation imposes a number of curbs on the practice, and margin trading – the practice of buying shares using borrowed money – is also less prominent than in some other major markets. That means fewer variables influencing share prices, which is also seen as a factor improving the accuracy of analyst forecasts.

“There are several constrains to arbitrage that is making the market much more inefficient than global peers,” says Rohit Beri, chief investment officer at ArthAlpha, who includes consensus target prices in his quant models for better stock selection.

“I was honestly surprised by how well this factor works in India. The market structure here is allowing us to use this anomaly.”

India’s market and its peculiar structure have been thrust into global spotlight this month after the nation’s regulator temporarily barred Jane Street Group LLC from accessing the local securities space for alleged index manipulation. The US firm has denied the allegations.

The restrictions on short selling have meant that traders looking to bet against stocks are effectively pushed into the futures and options segment, which has grown exponentially in recent years amid the retail-investing boom.

Derivatives turnover in the South Asian nation is more than 300 times larger than cash equities, versus a ratio of four times in the United States and 15 times in South Korea, and Jane Street’s trading strategy made use of this quirk to earn billions of dollars.

Stock boom

Indian stocks have been on a tear in the past decade, with the benchmark NSE Nifty 50 Index on course for a 10th straight year of gains.

And while the long-short strategy may appear lucrative, a trade that bought and held 20% of the top 200 stocks with the highest expected return based on analysts’ target prices would have returned 479% in the last 10 years.

As the market has grown, the quality of analyst research too has improved, with better corporate disclosures and sector specialisation also playing a part in raising the accuracy of forecasts.

Vitor Azevedo, a professor at RPTU University Kaiserslautern-Landau in Germany, who co-authored a study on analysts’ recommendations and mis-pricing across the globe, says the results show that India fared better than most emerging markets.

“India stood out, with statistically significant returns from following ratings,” he says, citing the study that looked at data from 1994 to 2019 and was published in 2024. “The strategy was giving returns consistently over the period we analysed.”

Some observers say that returns from a long-short strategy based on target prices will likely moderate as regulatory frameworks evolve and trading technology and models become more sophisticated because this will help correct some of the factors delaying price discovery.

“Quant investing is still in its early stages of development in India,” says Karthik Kumar, who manages a quant strategy at Axis Mutual Fund. “As more funds adopt this approach and explore different data sources, some of the current and more basic signals might cease to be relevant, like it has happened in the West.”

(Methodology for long-short strategy: The hypothetical portfolio following analyst target prices buys the top 20% of stocks with the highest sell-side expected return and shorts the bottom 20% within India’s top 200 stocks.

(Expected price return is based on each stock’s average analyst target price maintained by Bloomberg and the portfolio is equal-weighted and rebalanced every month. Stocks without analyst coverage are excluded from the benchmark, and trading costs are not being considered). — Bloomberg