Of Index Funds and ETFs— Some thoughts

(This appears in today’s edition/s of Deccan Chronicle)

(http://epaper.deccanchronicle.com/articledetailpage.aspx?id=11142075 )

 

 Globally, it is tough for mutual funds to beat the performance of broad indices. Yes, there would be a handful that beat the index, but looking at the rearview mirror, picking them up, can be hazardous.

In India, our Index is not the best representative of the market. If we take the current market, over 40% of our index weight comes from one sector- Banking & Finance!.

This is what our NIFTY looked like a few days ago:

(Source: https://www.nseindia.com/content/indices/ind_nifty50.pdf)

 One sector keeps pulling the broad indices. And individual stocks’ weights also can distort the picture. Every fund manager would be overweight or underweight each of them according to his judgement and expectations. However, collectively, all the investors move the stocks different to what rational expectations are. In addition, a fund will not limit its portfolio to stocks out of an index (unless it is an index fund). As I am writing this, the NIFTY is headed towards an all time high driven by stock prices of some private banks. A mutual fund manager would use his discretion and some may be of the view that the private bank stocks are expensive and put money in some other place where they find value. They cannot be chasing momentum.

A mutual fund manager tries to pick value, growth and future performance. In the early days in India, you could beat the indices easily as the index had a lot of companies that were boring or dying companies. And a lot of undiscovered opportunities were waiting. Today, the index has become packed with high momentum stocks and the chances of new discoveries has reduced due to the number of investors as well as the easy availability of information. In addition, the promoters are aware of the wealth creation abilities of the stock markets and are always eager to spread their story.  All this makes it difficult for a mutual fund manager to keep constantly beating the indices.

It is said that globally less than five percent of mutual funds beat the broad indices. This will happen in India also.

This makes a strong case for ‘passive’ investing through index funds. You know what you are in for. You could either do a SIP or keep making lump sum purchases when you have money. Personally, I would recommend a SIP process and when we do get some extra moneys, try for some direct equity if so inclined.

The exchanges keep revamping their indices to keep adding the big names and trim the ones that do not deliver. In a sense a passive fund management is happening behind the scenes. If you look at the Sensex of just 30 stocks ( the BSE Sensex was created sometime in 1980-81 with 1978 as the base year). Stocks that were in the Sensex include names like ACC Ltd, Bombay Dyeing, Premier Automobiles (defunct), Nirlon Ltd, Centure Textiles, Proctor & Gamble, Mukand Ltd, Tata Chemicals etc… Thus, the Sensex itself keeps evolving and tries to include companies that are becoming bigger and excluding companies that do not keep pace. And including a company or dropping a company from an Index has its own consequences. Many global funds are happy with passive tracking and will mimic the index. All index funds will sell the stocks that go out of an index and buy the new entrant.

Thus, the broad indices, while they will have their excesses either way ( I seriously doubt if the index will ever be at a perfectly fair valuation ever… Everyone’s perception is different and funds flows in to markets are a big determinant of the indices) are a fairly good way to participate in the stock markets. .

And we will have two choices- Either use an Exchange Traded Fund (ETF) or an “Index Fund” floated by a Mutual Fund. Personally, I would pick an ETF for the simple reason that costs are lower than in an Index Fund. The procedure for buying and selling is different. ETFs are bought and sold like stocks. So it will call for an action on your part to make a buy. You could easily set up a SIP with your broker on most online platforms for stock trading.

If I do not have the time and the skills for direct equities, I would suggest the ETF route. You can have ETFs for all indices. It is a matter of time.