The Argument for Index Funds

I recently read an article in the personal finance section of leading national daily where the author reviews a book written by the head of a leading financial advisory firm of India, Mr. Parag Parikh. The book is titled Value Investing and Behavioral Finance. The author has argued against the utility of investing in Index funds. I have not read the book; my response is based on the review of the book in the said article.

The most important argument put forward by Mr. Parikh is that the Index represents a bunch of costly stocks. According to him the high market capitalization of the Index stocks represent the expensiveness. This is over implication to say the least. He also argues that therefore buying an Index defies the basic of value investing. It is obvious that Mr. Parikh values Value Investing. After all, he is a stock picker (mostly for others, for a fee) and he must have his strategy of picking the better stocks while other get the lemons. It’s a different matter that there are hundreds of other brilliant stock pickers attempting to do the same thing. Who will win is anybody’s guess. What he forgets is that the Index investor believes that none of the popular stock picking strategies can succeed consistently over the long term (15 – 20 years). Index investing is NOT value investing, rather it is the renunciation of any stock picking strategy.

Secondly, when he talks about Index stocks being the ones with largest capitalization, he obviously has a narrow Index i.e. SENSEX in his mind. His logic is flawed on at least two counts. Though most of the Index funds in India are tracking either the SENSEX or the NIFTY, there is at least one Index funds which tracks more than 90% of market. Such broad market based Index funds are plentiful in the developed markets. Also, his suggestion that the narrow index is an expensive one is flawed. Take a look at the following chart:

INDEX	P/E
SENSEX	19.73
BSE 500	20.26
BSE 100	21.91
BSE 200	20.73

Source: www.bseindia.com As on Monday, July 20, 2009

The ‘de indexing’ strategy that Mr. Parikh has found to be more effective than investing in an Index fund, does not make an Index investor an inferior investor. First of all, like most stock picking strategies, this is a case of having a 20/20 hindsight; usually these strategies do not succeed when applied to the future. Also I am not sure if the calculation takes into account the brokerage expenses. Secondly, long term capital gain has not been tax free always. Has that fact been taken into account? Most important of all: Index investors are not looking for chart topping returns. They are looking for the Market return, which they will achieve.

Mr. Parikh also laments the absence of a benchmark to measure the performance of Index funds. A benchmark is not needed for Index funds. What is the benchmark for gold or the U$D? The tracking error is the measure of performance of an Index fund. Equity funds need a benchmark to justify the higher fees. If they outperform the benchmark, the higher fees are reasonable.

At the end the reviewer is left in a dilemma. He is flabbergasted that the bulk of the fund managers underperform the index and the index itself is a sub-optimal (I guess what he means that a few funds will outperform the Index, but which ones somebody please tell me) performer. He wants to be the topper but does not know how to be the ONE.

Some people will be happy to perform reasonably well, without bothering whether they beat everybody or not. Index Investing is for those people. They will at least beat the Broker J