Index funds: A simpler solution
Growing up, I loved watching Wall Street movies — the pace and glamour made them exciting and fun to watch. These movies depicted that wealth creation was a secret sauce that only the super-rich had access to. I had then assumed that information was disproportionately available to the wealthy, giving them an unfair advantage in creating wealth.
Later, I realised that everyone has an equal opportunity in wealth creation when I got a chance to see Warren Buffet in Omaha for Berkshire Hathaway’s annual meet up . It may sound boring — two old men (Warren and Charlie) talking about the finance and the economy. But the way they hold the attention of the more than 50,000 people present is a marvel to watch!
An important lesson one gets at the meet is that investing is easy but hard to execute. It is 10 per cent process and 90 per cent psychology. And do you know the secret sauce? It’s doing nothing.
At the event, Warren Buffett also won a 10-year-old bet. A bet that no top hedge fund (chosen by a reputed firm) will beat the S&P 500 (the most popular index available to everyone). And he beat it pretty convincingly.
It proves that simplicity works; simplicity makes it easy for us to do nothing. Simplicity also allows us to focus on the more important things in our lives. Today — with the world getting bigger and people getting busier — index funds provide that level of simplicity in investing.
Stock pickers to fund pickers
Today, equity investors have moved from stock pickers to mutual fund pickers. With over 5,000 options, taking a decision is hard. Index funds provide a whole new level of simplicity to this process.
Instead of choosing among 150-200 mid-cap mutual funds, you can select the mid-cap index fund and put your worries to rest. As for returns, they are not just good, they are great! Most mutual funds today in the large-cap category are failing to beat index returns, while outperformance in the other categories has come down. In mature markets, such as the US, outperforming the index is rare.
Costs are low
Costs are measured by the total expense ratio (TER). This is the amount that the mutual fund earns for its service. TERs for index funds are much lower. Although saving 1 per cent may not matter much for 1-2 years, for someone who is investing for more than 20 years, the costs add up.
Globally as well as in India — money follows strong performance. Investors need to understand that consistent outperformance cannot be expected. Every active strategy and style has periods of outperformance and underperformance.
The top 10-20 mutual funds rotate every 1-2 years. With index funds, there’s no fear of under-performance, and, therefore, makes it easier to manage the 90 per cent psychology that Warren Buffett talked about.
While choosing active mutual funds, investors need to understand the underlying philosophy or the fund house, the fund manager’s style etc before purchasing a fund. Blindly looking at 3-5 year performance is something that is not recommended. Investors should watch out for mean reversion — it means that funds that do well yesterday will do badly tomorrow.
Instead of doing extensive research and comparative analysis of all mutual funds, index funds offer a simpler reality.
Fund manager risk
Mutual funds are subject to market risks. That’s a better definition of index funds! Active mutual funds are subject to market as well as fund manager risks. Over really long-term periods, the risk increases more.
It’s hard to take a call on a specific fund manager or a fund if you’re looking to invest for 10-15 years. Index funds remove the risks of fund managers completely.
Risk is consistent
Risk in an index fund is the same as it was 10 years ago. An active large-cap fund has a volatility range of 6-20 per cent (12 per cent for an index fund). So, an investor holding a large-cap fund may carry the risk of a small-cap fund.
Risk is becoming an essential topic of discussion now. A small-cap index fund has the risk of a small-cap strategy, but an active small-cap fund will be a hybrid of small, mid and large-cap stocks. There’s a famous saying “As advisers, our job is to manage risk, not returns.” Returns, as most people know, are volatile and hard to predict.
Index is forever
Any investor who is looking to invest for more than 10 years should have index funds in his/her portfolio. Each index fund has a track record of 15-20 years, giving a visibility of returns in the future.
Also, the index will adapt to the changing political and business climate in India. For example, 15 years ago, the index was mainly industrials and energy. Today, it is mostly financial services and tomorrow it maybe something else. Index ensures that an investor always has the best-performing stocks at all points of time. So, investors buying index funds today will never have to worry about being stuck with a lousy portfolio in 5-10 years.
The S&P 500 index launched over 40 years ago was the first index fund in the world. Today, it is the largest and most famous index fund. It has survived the test of time and thrived. To conclude, if you’re busy and if you’re thinking long-term, think index funds.
The writer is head of passive fund business, Motilal Oswal AMC