To Index or not to Index

Idea of this article is to understand what active and passive investing is and some arguments for and against index investing in India. The text below may not provide an answer but is aimed to discuss some popular studies on the subject.

Lets understand first that passive investing can exist only if active investing exists and not the other way around. If active investing didn’t exist, there wont be any trade, security prices would be at a stand still – thankfully that’s not the case and therefore people would always trade (owing to different needs of people or simply because of difference in opinion). And what we mean by ‘passive’ investing is simply to piggy back on active investors. We are implicitly putting our bet on the popular opinion about some of the largest companies in the economy and their growth prospects. And who are these people who have made the biggest bets – the institutions (like mutual funds, insurance companies), the big domestic and foreign investors and small investors. Now as majority of the amount flowing through is from institutional investors, the retail investor is more of a price taker with his/her SIPs allocating units based on whatever he can but with that fixed amount (assuming average investor doesn’t gain much from market timing on lump-sum). At the same time, active investors would be driven by business goals and/or investment goals to make bigger buy or sell decisions and hence lead to any meaningful change in price. A passive investor would be part of the deal implicitly and be a price taker. Eventually, the biggest driver of change in price of a company is the company itself, even active investors are price takers but not as much as passive ones. It’s the degree of passiveness I want to emphasis on rather than hard categorization.

Despite all these underlying complex business decisions, the markets somehow manage to rise like clockwork on a long term basis (don't forget this though). What leads to such a harmonious steady growth in the markets, what leads to this order from the underlying chaos. Are top 50 companies that are responsible for ~75% of the profits at any time in the history so consistently better than previous top 50 (or themselves for most of the part). Or does it mean that markets tend to discover potential of companies slowly and hence value them gradually upwards. I would probably think that’s the case, because if most of the market participant could realize the true potential of the companies, the price would be bid up and no gains would be left to be realized in the future. The gradual but steady movement seems to imply that majority of the participants (big and small) do not realize the true potential (up or down) for all the companies. And hence market as a whole is a mystery for most participants. Although only 50 companies are making majority of profits any given time, there is no market participant who can value all the 50 all the time at fair price. This I think leads to difference in opinions and prices tend to swing around fair value.

Can this be expected in future? I think yes, even Warren and Charlie would agree that most businesses are hard to understand – meaning their future cannot be predicted with a high degree of confidence. And so we can expect that markets will gradually unfold and no single participant would be an expert on the whole market. But can someone be an expert on few of the companies – of course yes. Am I that person or can I find someone who can be an expert on some of the companies? Is it easy to become an expert or find an expert? Even if I find an expert how much would they charge me? Let’s tackle these questions, one by one.

For most individual investors, it is difficult to understand and devote time to the vocation of business analysis. It is a devotional activity and success is not guaranteed. And therefore, leaving investing to professionals (active or passive) is best aligned with financial health for most. How about finding an expert in such a scenario?

Let's look at some data - 10 year performance for US mutual funds shows that ~90% of the managers fail to beat the market.  In India, situation is less extreme, and 40-60% of the the managers are able to beat the market depending on the type of fund one chooses. So there seems to be some evidence that at least in India fund managers are able to beat the indices. . However the study hides more than it shows. For example - it is not shown how many funds were taken into analysis. Was their survivor-ship bias for Indian funds. The above mentioned study however concludes by saying that even in India active investing shall work in future, however I don't find their arguments impressive enough to form any opinion on the subject. What is missing is that by how much are the active fund managers able to beat the market and how far are the laggards? Is it a skewed distribution where only few clear winners are emerging or a narrow distribution where it is difficult to judge who will outperform in future. 

To answer the above questions would require a rolling time analysis for the funds at various time and that is not easily available, so I took the snapshot data provided by AMFI as on 9/11/2020 and here is what the data shows. There are 28 schemes with 10 year history present, of which 13 have beaten the benchmark return. The funds that beat the benchmark had average return of 11% while funds that didn't meet the benchmark had an average return on 7.5%. So the spread is meaningful for further investigation. What comes across is that its not very easy to define which would beat the index and which ones would not. Some value funds beat the market and some didn't, similarly, some funds of large fund houses HDFC, ICICI were present in both winners and laggards. So their is not a clear differentiating factor. 

As for index, 10 year rolling return average for Nifty 50 is around 11-13% and the range is from 6%-20% while for Nifty Next 50 is 10% - 26%. as described in this study  Another study on Sensex shows similar results on index performance. It shows that with index investing, chances of one attaining low returns (<5%) are relatively low over long time duration. Same cannot be said for mutual funds.

Parag Parikh did an interesting study of showing that stocks that went in the Sensex perform worse than the stocks that went out of the Sensex. This to me is however an irrelevant data point. The study does not show how the Sensex as a whole perform w.r.t. the companies that went out. If such is the scenario that companies that are moving out of index are beating the index, than they would eventually be part of index. It is simply doesn't make sense to pick parts of index that are underperforming and say that index as a whole is laggard. 

One key argument against index investing is that Indian indices do not represent the broader Indian markets. This however is not exactly correct due to two reasons - 1) Top 50 companies cover 66.8% of the total market cap,  Top 100 companies cover 76.8 % and Top 200 cover 86.7 % of the market cap. 2) One can invest in these indices by funds that track these indices or ETFs, there are concerns on tracking error but options do exist. See here for the full list. This study has more such arguments against index investing but I think author has presented data selectively - example only stocks that leave the market are shown (and how they were dropped when they lost market cap). Isn't that the definition of index? Why are stocks which enter the index and that gain market cap further are not shown? Broadly, the question is not weather index in efficiently reflecting the economy or not, its about what returns can expected from the available options. If one is satisfied with 11% return with moderate risk, it does not matter if that's reflective of the whole economy or not. India may never reach such level of efficiency as US in short to medium term due to unorganized sector.

This video has anecdotal arguments in favor of index investing and are mostly logical but is way too opinionated to consider arguments in favor of active investing. Of the 12 fund that beat Nifty of possibly, say 100 (after adjusting for survivor-ship bias)? That's a 12% chance of beating the index. Is that difficult to achieve? Is it worth achieving? I don't know the future performance of fund, but there are few fund (ex: PPFAS, Mirae) that have consistently beaten the market in past several year and by good margin of around 5%. Can they perform similar for next 10 years? How bad will they perform if they don't beat the market? What is cause of out performance and is that durable?

As mentioned at the start, passive investing cannot exist without active investing, however it is difficult to find winners of active investing and that's where I think some balance needs to be maintained. Typically at this point people advise to set a return expectation and allocate portfolio basis that. But I think that's a foolish way to look at reality - of course I want a 26% return but can I get it? Do I deserve it given the knowledge I have?  Better way to look at reality is accept one's knowledge on the subject and take decision accordingly. In the end it is not important to beat the market but to achieve maximum returns given your understanding of markets and businesses. If I am a know-nothing investor why should my expectations be 26% and not 11%. And probably index investing is the way to go then... however both hard work and luck are needed to get market beating returns - and you can't beat market by buying index and that leaves us with only one option - active investing.