PASSIVE INVESTING (ETF’S AND INDEXING)
By CAPAMIT02 Jul, 2016

PASSIVE INVESTING (ETF’S AND INDEXING)

Some lesser known facts to the common retail investor which are stated below:

FACT 1: “Nearly all active diversified equity funds as a group are under-performing on a four year rolling return basis, with empirical evidence, demonstrating less than 8 % of active fund managers to have marginally beaten the benchmark index”.

FACT 2: “Outperforming index is a random event and it is sheer luck. Past performance has little or no predictive value for the future”.

FACT 3: “The elusive search for active fund managers, generating “True Alpha” has become harder given the complexities of the present day market dynamics.

FACT 4: “Perhaps the residual logical choice for the investor, who is looking to have long-term equity allocation in his/her portfolio, is to use broad market index fund”.

In many classic active versus passive debates in Indian media and private interaction, proponents of active fund management have always claimed that Indian markets are different and Indian fund managers will always be able to outperform the benchmark or generate Alpha. The arguments given are manifold. The most common one is that Indian markets are inefficient and the fund managers are privy to information or their level of intellect is much higher than the market. This argument is in direct contrast with the reality of developed markets, where over the long-term nearly 80% of actively managed funds under perform the indices.

It has often been argued that individual active fund managers are consistently able to exploit anomalies and aberrations that may exist in the market and while considering out performance/under performance one should look at longer periods. A longer term investigation, on a four year horizon, computing rolling return analysis in order to avoid any aberrations, when carried out displayed less than 8 % active fund managers, outperformed the benchmark CNX Nifty Index. The results are significantly lower when viewed on a 10 year rolling return period!

The most common method by which the majority of investors invest into a fund is based on past performance or rather past out-performance. The results from study shown above reveal that this method is highly unreliable. An investor seeking long-term exposure in equity is likely to get disappointed, by remaining under an illusion that Alpha or out performance is easy and that every fund manager will deliver it consistently.

As such indexing should form a “core strategy” for both institutional and retail investors alike.

Passive Investing is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn’t entail any forecasting.The idea is to minimize investing fees and to avoid the adverse consequences of failing to correctly anticipate the future. The most popular method is to mimic the performance of an externally specified index. Retail investors typically do this by buying one or more ‘Index Funds’ or an “Exchange Traded Fund”. By tracking an index, an investment portfolio typically gets good diversification, low turnover and extremely low management fees. Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.

In the Indian perspective, the investment objective of indexing is ideally met with the “GS Nifty BeES” which is a passively managed Exchange Traded Fund (Etf). GS Nifty BeES provides investment returns that, before expenses, closely correspond to the total returns of the securities as represented by the “CNX Nifty Index”. However, the performance of scheme may differ from that of the underlying index due to tracking error. GS Nifty BeES tracks the CNX Nifty Index and is priced at 1/10th of the CNX Nifty Index, looking to replicate CNX Nifty returns. It is listed and traded on the capital market segment of the NSE and can be bought/sold as 1 unit and in multiples thereof, thus offering a simple and transparent process. The investor gets the diversification benefit as he is able to get exposure to the complete basket of 50 stocks encompassed in the Nifty. An earlier concern with investing in Etf’s in India is that they are not very liquid. However in the last 5 years, active participation in Etf’s has increased exponentially by institutional investors looking to temporarily park cash during portfolio transition, arbitrageurs to carry out operations with low impact cost, traders who do not have enough capital to invest in index futures, first time investors, long term investors and investors looking for a low cost diversified portfolio.

We would like to reiterate the words of Mark Hebner: “The only way to “beat an index” is to invest in something other than the index. Why would you, when the only source of long term risk and return data is the index? Since you can’t beat the index, be the index”.

Furthermore in the words of the legendary Warren Buffet: “Most investors, both institutional and individual, will find the best way to own common stocks is through an index fund which charges nominal fees. Those following this path are sure to beat the net results i.e. after fees and expenses delivered by the great majority of investment professionals”.

Happy Passive Investing!

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