Index Funds – Yet to Make its Mark Within the Indian Markets

John Bogle, the apostle of indexing, was the first person introduce index funds to the world four decades ago. An idea which was initially dismissed as a folly has today turned Vanguard, the biggest player in index funds, into a $5 trillion company.

Internationally, index funds have gained popularity and a number of passive investors have taken resort to index funds to build their portfolio. But does this actually help to make hefty returns in an emerging economy like India as opposed to a developed superpower such as the US?

India is still in an evolving stage where indices would give stable returns but with so many flourishing companies why would you stick to only the large caps of the market? Also, an apple should be compared to an apple and not an orange, similarly, India cannot be compared to the US atleast not now!

Aping the US economy by investing in index funds would only give you meagre returns, hence, Indians must actively invest till India is developed enough for a like to like comparison with the States.

Are Indian Markets Any Different?

India, being a developing country is advancing at an extremely fast pace and growing at a rate of eight per cent while the US is growing at 2-3per cent. Additionally, 77 per cent of the US GDP comprises the service sector alone while only 53 per cent contributes to India’s GDP.

Manufacturing and agriculture sectors are important in India which help to start more businesses and inturn create sources to generate alpha. Moreover, India and US have stark differences when compared especially in terms of their market capitalization. The lowest market cap of a Company in S&P 500 is close to $20Billion whereas in BSE 500 it is a mere $0.09Billion.

This very size difference can turn out to be a gold mine for opportunities. In the US, the big will continue to grow bigger but the alpha that a growing Indian company creates will be much faster than an existing bigger American company in the same time period. Hence, there are innumerable opportunities emerging day in and day out. Don’t you think it is essential to catch these growth packets to generate the alpha needed?

The Flaw of Indices

It has also been observed that more often than not, a rejig in the indices creates a life-time opportunity to acquire the shares excluded from Nifty50 from a long-term perspective. Confused as to how this can happen? The removal of securities from indices means that all fund managers and institutions will get rid of that stock as they will not be able to mirror the returns generated by the indices if the stock is held in their portfolio. Also, when a stock or a sector underperforms, the indexing system removes the same from the composition. This creates a double-whammy on the stock or sector whose prices have not only nosedived, but have also been hammered by the relentless selling of institutions. However, this doesn’t mean that the inherent quality of the company is dampened instead the intrinsic value of the company is still intact and the stock now becomes a good buying opportunity, but due to flaw of Indexing, the stock had to be sold.

A closer look at Nifty will also show that a whopping 37.7per cent of the index is encapsulated by the financial services sector alone. Due to the lack of proportionate distribution, Nifty doesn’t entirely show the true picture of the economy. Also, piggybacking on Nifty or Sensex which mainly comprise liquid and active names in the market might not be the most ideal thing to do as these might be overvalued. Expectations of a stable return can be met but if you are looking out for “the excess” then you always have to play it smart. “The excess category” of fund managers are well aware of the tracking error issues that come along with indexing, hence they prefer to invest through active funds in India where smart managers can outperform the equity benchmark indices as opposed to the US where majority funds underperform the benchmark.

The Last Words

Jumping into the indexing bandwagon isn’t promising enough! At the current stage, index funds are not the most efficient way to make returns.

As long as actively-managed funds are able to create value for investors by outperforming the benchmark, scope for abundant investment in index funds does not seem very promising.

It is not about refuting the ideologies of legends such as Buffett, Bogle and Lynch but it is about understanding market timings for index funds. And at least for Indians, which is clearly not now!

The writer is the Founder and CEO, Samco Securities