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

'Direct' dil se

Ever since SEBI allowed abolition of entry load for direct investments into mutual funds I was eager to invest "directly" in MFs. The easiest process is to go to the AMC's nearest office with a properly filled up form, photocopies of necessary documents and you can bypass the agent and agent commission. But this is not the easiest thing for me to do. Its very difficult to squeeze out a couple of hours during the working hours of the financial industry. Also suppose, I want to cancel the SIP, switch funds or do any such transaction. I have to fill up a form a place, courier it to the office of the AMC. It involves several days delay before anything is done. So what I want is online access to carry out the transactions, and also to further invest online. Incidentally, most of the fund houses nowadays allow online portfolio management. But there is a catch. You first have to invest with the fund house through a broker. Then apply for a password with the registrar. The process may vary a little bit from AMC to AMC. But the problem remains the same. You cannot have online access and exemptions from entry load very easily, sitting at home. However Fidelity allows direct online investment. You have to register with them; fill up a form, send it to them along the the necessary photocopies, attested properly. This method also requires some effort on my part, and I hate to work. ( I do not invest in Fidelity funds as of now, but that's not the issue here)

A few days ago all that changed. Birla Sun Life allowed me to open an online account with them on the basis of a past investment that I had made through a broker. Incidentally I had put my email ID in the application form. I had to fill up some data about me ( to confirm my identity) and in 5 minutes I was ready to go. And the best part of it is that I can choose my subsequent investments as 'direct' . It also allows me to use netbanking facilities of multiple banks. Sweet. I didn't have to move a step out of my home.

You must be wondering why I need such a facility. I hate paying entry load, when all my agent does is to collect the form from me and deposit it with the AMC. Of late, I am moving towards using Index funds as my core holdings. There are a few good Index Funds with no front end load, no exit loads either if you stay invested long enough. My necessity of such an online investment avenue is for moving my surplus money out of my savings account into debt funds ( short term, money market, medium term) for periods ranging from a few weeks to a couple of years. I hate to redeem my equity funds to such an extent that I want to forget that I even hold them. So investing in equity funds in such a manner is not my primary objective. Birla Sun Life has a few good equity offerings which might interest you. If you too hate paying entry load , this may be a good option.

( The above article is meant for information about MF investments, and not an insight into my energy levels)

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.