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

Index at last

The New pension System that has recently been announced by Pension Fund Regulatory and Development Authority (PFRDA) intends to use Index Funds to provide investors with equity exposure. The maximum equity exposure is capped at 50%. The maximum percentage of equity exposure of not that important. Whats important is that this bill has the potential to produce a large number of long term equity investors.

Indians tend to use long term debt portfolios ( eg LIC policies, PPF) to supplement the retirement corpus. Equity investment is either seen as an easy and quick way to make a lot of money, or as too risky an investment which should be avoided. For most of the existing equity mutual fund investors the fund selection depends on the schemes suggested by the salesperson, the current 'hot' funds or the NFO promising a fabulous return. Long term means usually1 year, and 3 years at the maximum. Even the so called investment experts used to proclaim 3 years to be safe time horizon for equity investments, at least till the early part of 2008. This bill in one stroke can change all that for a large number of Indians, who most of the time have no idea about the underlying instruments that are used in there long term investments, or simply not interested to know.

But I am most excited about the decision to use index funds to provide this equity exposure. In India the concept of Index Funds is at a very nascent stage. Though there are a number of index funds only 3-4 funds have asset size of more than a hundred crores. This is minuscule compared to the total AUM of the Indian MF industry. I am not sure why it is so. One thing I know that most of the investors are not even aware of the existence of such funds, just as most people are not aware of the existence of term insurance plans. No newspaper carries daily NAVs of index funds, index funds are rarely among the top three or top five funds of the month, and no investment planner recommends these funds on Indian media. Compare this to the US, where the Vanguard Total Stock Market Index Fund has an AUM of $77 billion i.e. almost Rs375000 crore and currently the second largest us equity fund.
Here, in a singe stroke PFRDA has launched Index funds into a higher level. This move has the potential to usher in a new era in the Indian investment scenario.