“I made the smartest investment decision of my life yesterday,” a friend told me over phone.
“Did you finally stop trading in share market?” I asked him jokingly.
“Shut up! What I did was to invest in a good index fund,” he said.
“And why did you do that?” I asked.
“You see, the index fund will keep my money safe as the returns won’t depend on the whims and fancies of the fund manager while my money will grow in line with the stock market,” he replied. “I believe every investor must have an index fund in his portfolio.”
Well, this wasn’t the first time I heard someone ‘sell’ me the idea of an index fund and why it’s a must-have in a small investor’s portfolio.
But I have never invested in index funds in the past, and don’t plan to do that in the future as well.
By the way, for the uninitiated, an index fund is a type of mutual fund scheme that invests in a basket of predefined stocks of an index (like the BSE-Sensex or NSE-Nifty) in an allocation that resembles that of the benchmark index.
So an index fund is like a passively managed fund, where the fund manager just has to buy and hold the stocks that form part of the index, and exactly in the same proportion.
In other words, if Infosys has 10% weightage in the Sensex, an index fund tracking the Sensex will also hold Infosys as 10% of its portfolio.
Anyways, there are several reasons I don’t like to invest in index funds. Here are three big ones…
1. Index funds buy high, sell low
Index funds largely track the market capitalization of companies that form part of the index.
So as a company gains in market capitalization (and thus gets expensive in terms of valuations like price-to-earnings or price-to-book value), the index fund manager has to buy more of it to get it to a higher weightage in his fund as well.
On the other hand, a company that falls in market capitalization and also in terms of valuations gets a lower weightage in the index. The index fund manager follows by selling a part of this company from his fund to match its new weightage.
An index fund is therefore an automatic mechanism to buy high and sell low. I don’t recall this tactic ever being given as a sane investment advice.
2. Index funds buy the past, ignore the future
Index funds tend to have the most significant portion of their assets in large, mature companies.
While this may sound a ‘safe’ strategy on the face of it, the problem with this it that the largest companies in a stock market index are yesterday’s winners.
They got to be the largest by delivering exceptional returns to investors over the course of many years, but in the past.
However, given the way industries develop, grow, mature and then decline, it is likely that most of these companies will earn much lower returns in the future. This is however barring a major reinvention led by a strong management team, which we anyways find in very few companies in India.
So an index fund is largely a portfolio of mature companies, many past their prime and with years of stagnation or decline ahead of them.
While I personally give a lot of preference to the past performance of companies, I am more interested in where these companies are headed in the future (not in terms of EPS numbers, but in terms of their businesses).
So a company that has a great future ahead of it in terms of business potential is what attracts me. And index funds don’t tend to hold such companies.
3. Index funds stick with stocks till they’re kicked out
The ranking of the 30 largest companies in India changes nearly every second as stock prices fluctuate up and down.
This isn’t a big deal for companies that are at the top of the rankings. However, at the bottom of the table, some companies drop out of the list while other companies manage to sneak into the top 30.
As a result, the BSE periodically drops some companies from the Sensex (that aren’t doing well in the stock market) and adds others (that are doing well).
What do you think happens before and immediately after the BSE makes these changes to the index (the Sensex)?
Since index fund managers have to follow the indices’ portfolio weights in order to minimize their tracking error, they hold on to the dropped companies till the last second while active managers sell them weeks or months before they’re dropped from the index (and for other reasons that are related to business performance instead of stock market performance).
Index fund managers also don’t start buying the newly added companies until they’re officially added while active managers already have the new (and better) stocks in hand.
Let me prove this with some examples. Here are six companies that have been excluded from the Sensex over the past 3 years. The red marks shows the day on which these were excluded.
Just notice the way these stocks performed during the one year prior to their exclusion.
I’m not sure if a good active fund manager would’ve held on to these stocks for so long (till they were finally excluded from the index).
This is especially true for companies like Mahindra Satyam, Reliance Communications, and Reliance Infrastructure that were deteriorating businesses for more than a year before they were excluded from the Sensex.
Data Source: BSE, Ace Equity
So why should I invest in an Index Fund?
Warren Buffett and Benjamin Graham have recommended index funds as one of the best investments for small investors who don’t have the capacity to pick their own quality stocks or mutual funds.
This is exactly what peddlers of index funds have been using as their rationale to sell such funds in India for long.
However the thing is that it may make sense for American investors to invest in index funds simply because the index funds there are far more indicative of the broader market (as they track indices that contain 500 to 5,000 companies).
In India, you have just two indices available – the 30 share BSE-Sensex and the 50 share NSE-Nifty. Such a small number of companies are anyways not indicative of the broader Indian market.
What is more, as I’ve explained above, the way the Sensex (or the Nifty) are constructed makes them just a shabby collection of big companies/expensive stocks.
So if a great company isn’t big or if a large percentage of its shareholding is held by promoters (which means a low free-float), it will never find itself in an index fund (while a smart fund manager would own it in his actively managed fund).
Alternatively, just because it is a big company and has seen a great rise in its stock price in the ‘past’, it will sneak into the index, and thus the index fund.
You don’t buy stocks like that, right? So why buy index funds that buy stocks like that?
As for my personal investments, I would any day prefer my own research and the stock picking skills of someone like Prashant Jain or K N Siva Subramaniam or Sukumar Rajah to grow my small wealth over the long term.
I find sailing in a leaky boat in a ‘supposedly’ calm river (index funds) much more dangerous than sailing in a non-leaky boat in high seas (carefully managed active funds…and there’re just very few of them).
What about you? Do you invest in index funds? If not, what’s your view on index funds? Let me know in the Comments section below.