Investing in the markets is definitely a skill, with people sporting multiple degrees in finance and statistics, implementing various techniques to outperform the market (Index). So, it might come as a surprise to know that over 80% of the actively managed funds underperform the index. To add insult to injury, there was an instance of a cat outperforming a group of analysts in 2012. This shows how difficult it is to beat the markets, even when highly paid professionals are put to the task. So, what’s the answer? ……… Index investing.
Index investing is ideally suited for passive investors who don’t have improbable return expectations. Low-cost structure and less effort requirement are just some of the other advantages. And make no mistake, this form of investing often beats all other investment avenues in the long run. While active investing takes immense skill, time, judgement and risk taking capability, index investing is devoid of any such complexities. And if active investing makes such little alpha (if any), one needs to question the need for active investing for most.
Index Investing: The Basics
The easiest way for retail investors to indulge in index investing would be through ETFs. This would give them a sense of action as well as hedge their portfolio (if they’re also into active investing). With the availability of multiple geographically and sectorally diversified ETF’s, investors can very easily mitigate risk.
Another option for retail investors is to invest in Index funds. So, what are Index funds? These are just funds which mimic the index as their portfolio. The stocks and their respective weightage would be structured just as the index is constituted. These funds would mirror the exact returns of the index with minuscule charges. Investors who want no headaches in their investing, should probably be looking seriously at these instruments.
How Effective is Index Investing?
Index investing? Why should we settle for average returns with no diversification …. right? That couldn’t be further away from the truth. Index investing is an effective strategy if you consider effort to return ratio. If 80% of the funds underperform the index with so much resources, one can even question the concept of active investing for the uninitiated.
In the 2016 Annual Shareholders Letter of Berkshire Hathway, Warren Buffet wrote as such “A low-cost index fund is the most sensible equity investment for the majority of investors. By periodically investing in an index fund, a know-nothing investor can outperform most investment professionals”. It should be serious business, if the titan of active investing vouches so strongly for index investing.
Let’s look at a few other characteristics of index investing which people overlook ……
Low Cost: This goes without saying. Index investing is extremely low cost. When the existing largecap funds charge up to 2.5% of the fund as expenses, index funds take a maximum of 0.1% as expense. Not to forget that 80% of the funds underperform the index by a good margin. There would be no frequent trading costs, as buying in is the only cost associated till redemption. Keeping it simple reduces the cost.
Diversification: Index funds are as diversified as the index itself. But luckily, the advantages don’t stop there. Investors can invest in index funds across the world. In the last decade, near 95% of actively managed funds across the globe have failed to beat the NASDAQ 100. And investors get an array of indices to choose from, varying from the Hang Seng index in Hong Kong to Infra index in India.
Good Returns: This is probably viewed as contentious. But make no mistakes, NIFTY has turned in a return of 10.2% CAGR from March 2009 to March 2020. This return beats most other instruments hands down. But this would possibly be the best returns in the market when we take effort into account. And as an example, NASDAQ 100 beats all these in the same period, aided by currency depreciation.
Any Risks Associated?
Every investment theme is subject to some risks. Some carry liquidity risk, some credit risk and so on and so forth. Index investing also carries some risks. For eg. NASDAQ 100 has a 20% weightage on 5 companies. Highly valued FAANG stocks also carry valuation risks. Another instance closer to home would be Yes Bank. Even when the company was buried deep under the grave, it continued to decorate the NIFTY 50 Index till March 20, 2020.
Furthermore, there’s also a redemption risk when the investment is in a foreign index. During the redemption process, which may take up to 5 days, the capital may be subjected to temporary currency risk. ETF’s also possess a liquidity risk, as in not getting enough buyers when you want to exit. However for retail investors this should not be a major problem, as their holdings would not be high enough to cause a liquidity issue.
Index investing can be a life saver for passive investors, but it’s a must have for active investors as well. A part of the portfolio for active investors, definitely needs hedging using index investing. It’s always better to have a diversified portfolio for an active investor, and index investing would be the perfect fit.
Having gone through this article on index investing, we also suggest that you go through the basics of investing here .