Is it time for index investing?

In almost about last couple of years, many of the equity mutual funds (MF) have underperformed the broader indices of BSE Sensex and Nifty 50.

The series of events unraveled with the introduction of Long-Term Capital Gains (LTCG) tax on equity and related instruments in the budget.

Then the categorisation of MFs across the industry by Sebi, then the IL&FS saga which led to crisis of the Non-Banking Financial Institutions (NBFC) to turmoil with Yes Bank and then the overall economic slowdown.

During this period, the markets were choppy with mid and small-cap indices correcting by over 30 per cent and 50 per cent respectively while some of the companies have eroded their stock prices or value by about 90 per cent, in some cases involved an extreme event of defaults and bankruptcies.

Within the same period, the larger indices had a rollercoaster ride not just touching multi-year lows but creating multiple all-time highs.

The period witnessed a general election along with few other State elections with mixed results to the current ruling party.

Despite higher market peaks in the indices, even the large cap oriented mutual funds couldn't deliver stellar returns and in majority of the cases have failed to even beat their benchmarks putting a cloud over the active management strategy altogether.

This is a result of evolving economic situations which made the investors to flock towards 'quality' where the returns have taken back seat over the safety of capital.

This made the migration of just 10 stocks hogging over 75 per cent of the index to just three stocks (HDFC twins and Reliance Industries) occupying about a third of the Nifty 50 while with an additional two stocks (Bajaj Finance twins) weigh near half of the index.

This skewedness in proportion of the index couldn't be reflected in a MF due to the regulatory restrictions and other mandates.

Though, MFs are passive instruments (where the investor doesn't directly involve in investment decisions) they're still guided by the fund managers and in a truly passive investment options like Exchange Traded Funds (ETF) or index funds, the investment fortunes are tied up with the performance of the index which is governed by the entire market participants and not a just any one or few in particular.

So, if one were to invest in the index, the index returns would eventually translate to investment returns. So, should one begin to consider investing in index funds or ETFs over the actively managed MFs?

ETFs represent a basket of securities (bonds or stocks) which is collectively traded as an index. Index MFs achieve similar results which also invest in the said index and not specific securities.

The biggest impediments in an ETF and index MFs are the liquidity and tracking error. The Net Asset Value (NAV) of an ETF unit is determined by the demand supply equation.

Due to the passive nature and lower transaction costs, these are relatively cheaper than the traditional MF investments. Despite the demat charges, they could still be cheaper.

In general, an ETF with larger Asset Under Management (AUM) experience higher trading volumes and hence higher liquidity. However, the liquidity of an ETF is not directly proportional to the AUM.

Tracking error is the divergence of the price behaviour of a position or a portfolio versus the benchmark. This could result in not measuring to the same level of gain or loss as per the intended index.

In India, the top-performing multi-cap equity funds over 10-year tenure has been in the range of 15-17 per cent while that of the larger indices is about 9 per cent.

The trouble with index investing remains in the flaws of how the markets behave. Like mentioned above, the index is driven by the constituents whose composition vary depending upon the prevailing market conditions.

The composition of the index varies as market-cap defines which stocks to stay or not in the index and how much weight they get within the index.

During a bull market or worse in a concentrated market like the current one, a few of the index components zoom in their valuations and thus occupy a higher weightage and vice versa.

At all the times, index investing tries to achieve to match the benchmark. This is quite contrary to value investing where one attempts to outperform the market not match it up with.

In the US where indexation has remained a raging trend with incremental flows attracting majority of the inflows since 2008 and for the first time in history of their introduction, they have a higher AUM than the active MFs.

Even in those matured markets, their lifetime has been about 30 years with respect to more than a century old stock market.

For domestic investors, the current choices in indexing or ETF and their nascent (performance) history doesn't yet give confidence to replace their entire MF portfolios.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)