India, Indexing And The Future
Retail investors in India are increasingly moving towards index investing strategies for their investments. This shift in preference has become more apparent since the onset of the COVID-19 pandemic in early 2020. At the present moment, most investors display a preference for indexing as a strategy solely because returns generated by benchmark indices in India have been quite significant during the period between mid 2020 and early 2022. But such an approach is representative of mere return chasing rather than an understanding of the essence behind the strategy. We must first understand the essential foundations of any strategy we follow. This would allow us to set up a concrete process around the strategy and stick to the process for long periods of time. Therefore today I will be delving deeper into the essential principles that make a case for index investing as a strategy, the applicability of these principles in the context of the Indian markets and also whether or not index investing can be seriously considered a long term investment strategy in India in the years and decades to come.
The fundamental philosophy of index investing as a strategy is mainly applicable to mutual funds. And it is closely tied to the Efficient Market Theory. The theory postulates that all the information available regarding a particular company readily available to all investors. Therefore, the impact of every bit of information would be accurately reflected in the price of its stock. This means positive information about a company would proportionately drive stock prices up and negative information would proportionately drive prices down. Therefore investors would simply need to pick a mutual fund that tracks the performance of a well diversified basket of stocks (most commonly a broad market index) and hold on to it for a considerable span of time.
But in reality markets are never fully efficient, at least not all the time. This is because complete information on various companies may not be available to all investors at a particular point of time. In the Indian context, this was especially true say 2-3 decades ago in the 1990s and early 2000s where critical information about various companies was available only to a select group of professionals such as stock brokers and mutual fund managers. This gave rise to mispricing in a number of stocks which presented investors with potential opportunities to benefit from such instances of mispricing. It also meant actively managed mutual funds gained in popularity. This was because the managers of such funds had easy access to the information that matters with regard to various companies. This combined with their superior technical acumen and insight, allowed them to deliver performance that significantly beat the broad market benchmarks at least in terms of nominal returns, before accounting for the costs and taxes involved. But the gap between the performance of the individual fund and the benchmark significantly reduces after accounting for these two factors.
And this is where index funds come in. Index funds involve significantly lower costs as compared to actively managed mutual funds. This is because such funds simply mirror the performance of a particular benchmark index, and therefore the role played by fund managers and the operational decisions they make is a lot less significant. This automatically means that the associated costs would also reduce. Furthermore, in today’s age of the internet and social media information is a lot more widely and easily available. This means that the discrepancy in the availability of information is no longer as significant an advantage as it was before. Therefore, markets all over the world have become a lot more efficient. The frequency of mispricing and the potential to benefit from it also reduces. This is borne out by the data found in the SPIVA (S&P Index Versus Active) USA report for year end 2021. The report attempts to compare and analyse the outperformance achieved by actively managed funds over broad market benchmarks over the preceeding 20 year period. The findings across various categories of funds for the 20 year period ended 31.3.2021 are given in the graphic that follows.
Quite obviously only a miniscule portion of actively managed funds have managed to beat their benchmarks over the concerned 20 year period. These findings are further backed up by the SPIVA India report for year end 2021. The findings of the report are summarised in the graphic that follows.
Clearly 50-90% of actively managed funds across all categories in India are outperformed by their benchmarks. These figures are not as comprehensively in favour of the benchmarks as those in the SPIVA USA report. This is because the Indian markets are currently a couple of decades behind the American markets in terms of their degree of efficiency and evolution. Over the next 15-20 years as Indian markets evolve and get more efficient, most of this disparity would be corrected and the outperformance figures of both reports should converge.
All of this information clearly points towards one major takeaway for Indian investors. Over the next decade and a half or two, the increasing efficiency and evolution of our markets are likely to leave lesser scope for mispricing. The potential for actively managed funds to leverage their strengths would automatically reduce. Therefore, low cost index funds are likely to be a much better option for retail investors as compared to actively managed mutual funds. This is simply because the majority actively managed funds do not achieve their stated objective of beating benchmark returns, after accounting for costs and taxes. And this would only become even more blatantly apparent in the years to come. Also, picking the few active funds that do outperform the benchmark is not everyone’s cup of tea. And given that index funds represent a better alternative to active funds, picking active funds is ideally something that the majority of us need not concern ourselves with. There is a case to be made for choosing the direct option when investing in active funds to enjoy lower costs. But while direct funds come with average costs of 1% to 1.5% per annum, index funds involve average costs of less than 1%. And given that direct funds and index funds are broadly subject to the same tax treatment, the cost advantage enjoyed by index funds over direct funds make them the clear winners.
Therefore apart from the case of those investors who already have a net worth that is significantly higher than what they need and thus can bear high costs, active funds would make very little sense for everyone else in the years and decades to come. But this does not mean that we can blindly invest in index funds. There are a few principles that we would need to follow when using indexing as a strategy. Firstly, the indexing strategy must be well aligned to our risk profiles. Our exposure to index funds must be dictated by our asset allocation strategy. Further, when picking index funds we must stick to funds that track indices comprising of the top 100 stocks based on market capitalisation (large cap indices such as Nifty 50 and Nifty Next 50 for instance). Index funds that track mid cap and small cap indices lack liquidity and have higher tracking error as compared to large cap index funds and are therefore quite risky. And finally regular rebalancing of our portfolios is a must, as with any other strategy. Therefore, while index investing will definitely make sense in years to come, our indexing strategies must be backed by a clear process in order for them to yield the best results.