Fifty Shades Of Indexing

In investing, every little nuance can be decoded with a metaphor derived from Shakespeare’s plays. It would be absolutely natural, therefore, to tag passive investing as a sedate monologue delivered by the peace-loving King Duncan and active investing as a blood-curdling conversation between the ambitious Macbeth and the three witches. The former, usually performed by replicating an index, does not seek to outperform the market. The latter, however, aims at just the opposite – outdo the market by all means possible.

Well, indexing as we know it is a here-and-now tale, one with a slightly hazy beginning, an inspiring middle and, clearly, a brilliant future. Investing has never been the same ever since index-based practices came to the fore, and it is with some satisfaction that I underscore some emerging trends in India’s indexing space.

In the beginning, let us acknowledge a straight-laced fact: passive investing is set for remarkable growth in our country. If recent numbers are any indication, indexing is right in the throes of exponential progress, thanks to an ever-enlarging group of investors who are, to apply a slightly risqué phrase, ditching active for passive. Sundry product manufacturers (read: asset management companies and their ilk) suddenly seem determined to roll out index-based solutions. And financial intermediaries too are gearing up to offer these to their clients.

It so appears that a whole new generation of investors have warmed up to passively-managed index funds, which they feel would do considerably better than their actively-managed counterparts. The latter seems slightly passé in a world that has grown acutely aware of index-driven investments’ benign nature. This awareness is not an altogether new construct, no; however, it has advanced especially significantly in the last five years or so.

For the record, every fourth or fifth new offer document worked out by fund houses, dutifully revealed by SEBI, is now an index fund of some sort. And a quick inspection of recent offer documents also suggests that smart new indices are being chosen for fresh offerings. Mainline indices like Nifty and Sensex are, therefore, no more the only functional indices.

“Sound and fury”

Well, I draw that sub-head, once again, from Macbeth (“life is a tale told by an idiot, full of sound and fury, signifying nothing”) to indicate the recent multiplicity on all fronts – the sheer number of index funds that are being rolled out, the use of diverse indices, the participation of new investors and so on. Sound and fury indeed of a different sort, I think.

This is a particularly weighty matter. Indexing in India is coming of age, a trend that is expected to gather momentum in the days to come. All this is pretty beneficial for the investing community. For the latter, indexing is a rather efficient way of pursuing value. Index funds, after all, are relatively less expensive to manage. “No need for a star fund manager bent on delivering alpha” – interested quarters are quite familiar with this classic rationale.

A rationale such as this requires wider support, I think. There is a great need for critical knowledge of indexing. More so because of the expanding product basket. Even more so because of the cutting-edge presence of exchange-traded funds (ETFs), which are the rage in many markets around the world. For the record, ETFs are typically index funds that are listed on the market; they trade like other listed securities.

At a certain level, a section of the investing fraternity is quite disgusted with the entire jingoism revolving around active management. A fund manager, for all the skills he may possess, has to overcome steep challenges to achieve meaningful outperformance. It is nearly impossible for him to beat the market every time, in every season. An index fund, with its passive style of functioning, does not bear any such burden. It is cheaper, simpler, more efficient in comparison. Typically, it is more relatable to the ordinary investor and a lot more convenient for him too.

Banquo’s ghost

For every Macbeth who is alive, there is a dead Banquo – else, the tale will never be complete. And the story of the ghost, whose appearance spooks the royal dinner, needs to be recounted too. So, let me begin by saying this: there are indices galore, but not every index is meant for you. You must choose carefully from among all index funds in order to optimise your gains.

Here are a few pointers for your consideration:

• Selection is everything – you must zero in on the index (or indices) that are absolutely right for your investment objectives.
• You must know enough about the indices based on which funds have been devised. Your selection will otherwise be imperfect, leading to an adverse impact on your overall returns. Under-performance will be ruinous for your portfolio.
• If you are genuinely convinced about the index-based investing approach, keep it at the very core of your allocations. Actively managed funds can then play the role of satellites by accounting for the rest of it.
• The big issue pertains to appropriate asset allocation. ‘What is my ideal passive-active ratio?’ is the most obvious poser before you. You may, for the sake of convenience, decide to allocate 50 per cent to each. But there is no universal rule for all.
• The next few questions will relate to the actual choice of funds (that is, essentially, indices). Is the most popular, large-cap index (say, NSE Nifty) appropriate for me? Or should I choose a more broad-based benchmark (maybe, BSE 200), keeping in view the mid-cap space? Will a thematic index (healthcare, perhaps) be in sync with my objectives? Well, keep the best, dump the rest is my recommendation.

To conclude here, I must emphasise that your risk appetite must determine your allocations. The investment products you finally choose must be in keeping with a vital factor – your tolerance level. Therefore, the index strategies you choose must also be based on this philosophy.

“But only vaulting ambition”

The Indian market for indices has shaped up well, thanks to new participants’ arrival and the consequent propagation of newer ideas. Indexing is not limited to Nifty and Sensex alone; there is a lot more variety today than earlier. Fund houses have used lesser-known but diversified indices in recent days. Even thematic indices are being exploited. As for ETFs, gold exchange-traded funds have proved quite popular. Ditto for certain bank ETFs, which many brash players have leveraged prudently to their advantage.

Whatever indexers may think, their journey has not been without risk. The latter begins with the assumption that active strategies are intrinsically smarter and that passive styles will always play second fiddle. Yet, history is replete with examples of outperformance by passive. Many quarters also argue that active cannot sustain for long; the idea that active fund management will be successful across market cycles is itself fallacious, it is felt.

Keeping this argument in mind, I urge investors to keep an eye on index funds with relatively limited tracking error. The latter represents the gap between the performance delivered by an index fund and that achieved by the index it replicates. Tracking error occurs because of several reasons. For instance, it can happen because of changes in index composition and the fund manager’s inability to catch up with such changes. Naturally, the higher the tracking error, the less efficient is the index fund in question.

All said and done, I foresee a great future for indexing in India. Remember, an index is a barometer of sorts – a measurement that captures a very large swathe of the market. Its status draws strength from its simplicity and its inherent low-cost nature. Pick up a broader index like the Nifty 100 and see its composition. Chances are you will feel good about it – it is the entire market captured in a single basket of one hundred stocks. The universe in a little orb – the brahmand caught in teen haath zameen – and no one is left poorer. The prospect is absolutely promising. To end with a quote from Macbeth, “if you can look into the seeds of time, and say which grain will grow and which will not…”

The author is a Director at Wishlist Capital Advisors