Know about ETFs, Your Passport to Index Investing

Stock markets have always been an enigma. Unpredictability dominates stock markets, which is why most investors are fixated on identifying some mechanism for decoding them. George Soros, a famed value investor, once said, “If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring.” This quote resonates with the idea of long-term investing, and more precisely, investing and staying invested, across market movements and cycles. But how does one implement this?

Mutual funds have long been considered as ideal investment products for investors, as they provide an opportunity to avail the services of a professional fund manager. Under active investing, professional fund managers take investment decisions duly backed by research and experience in the hope to generate alpha. However, this is easier said than done!

Indian markets are turning ‘informationally’ efficient day by day due to the ever-increasing quantum of money being managed by professional managers. Hence, the ‘outperformance’ of individual fund managers will increasingly be short-lived and change hands. Why does this happen? This happens because the stock market acts as a vast data processing machine where no single person or group has enough information to determine price. Thus, the only way to mitigate the risk of underperformance through incorrect stock or fund manager selection, is to participate in the index through ETFs (Exchange Traded Funds) / Index Funds, commonly termed as ‘Passive Investing’. There is an old saying which goes “If you can’t beat them, join them!!”

Passive investment products such as ETFs / Index Funds, provide returns similar to that of the underlying index, except for some variation due to fund expenses and tracking error. It should be noted here that index investing is a very natural progression for most of us as an index is the first barometer that we look at to understand how the stock markets have fared. An index has top-of-mind recall as compared to individual stocks. Most of us may not remember the performance of individual stocks over various time periods but it is more likely that we will remember how an index has performed. For example, it is easier for most of us to recall what the Nifty50 Index or Sensex was during the last fall in March 2020 but the same may not be possible for individual stocks.

As ETFs and Index Funds track an index, the underling portfolio and weights are clearly defined and therefore transparent which means that investors know at any given point of time where their funds are being invested. For active mutual fund schemes, one needs to constantly review and keep track of the scheme and fund manager performance at regular intervals. It is important to mention here that benchmark indices are continuously evolving with changes regularly made depending on data-backed analysis. Thus, in effect, investors are delegating the task of portfolio management to the collective wisdom of the markets, instead of relying on any individual fund manager. Every time there is a change in the index, the fund portfolio is rebalanced to reflect the latest index composition. For e.g., by investing in an ETF or Index Fund that tracks the Nifty50 Index or Sensex, one is certain of investing in a basket of large-cap listed blue-chip companies in India today or in the future without having to constantly keep track. This reduces constant oversight on the portfolio making it simpler to manage. Your portfolio in a sense is on ‘auto-pilot’.

Further, the most important factor that we tend to ignore is ‘cost’. Passive schemes track an underlying index and do not involve active stock picking and constant churning, resulting in lower fund management charges. This effectively translates to relatively lower total expense ratios as compared to actively managed schemes which in effect means more of your money is invested and working for you. Thus, index Funds / ETFs not only make your investment journey simpler but also more cost-effective. Warren Buffet famously said, “Investors should remember that excitement and expenses are their enemies”.

Index investing, a simple idea, but one whose time has come. With the current penetration levels of mutual funds in India significantly lower than global averages, it is likely that the next growth cycle will be driven by passive investing options due to its inherent cost advantages and sheer simplicity. While the current pandemic situation does not allow investors to venture into leisure traveling, let ETFs/Index Funds be your passport to investing in India’s growth story.

The author is Head ETF, Nippon Life India Asset Management Ltd

DISCLAIMER: Views expressed are the author's own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.