Should you ignore Buffett and opt for index funds?

Apr 8, 2014

In this issue:
» Daiichi Sankyo makes a loss in Ranbaxy
» China is not keen on stimulus measures
» Indian banks better placed to withstand shocks
» India's tax laws are very complicated
» ...and more!

Should one invest in actively managed funds or should one put his money in passively managed funds such as index funds? An article in Moneynews makes a case for the latter. And this by a comparison with Warren Buffett's performance.

First of all, what are index funds? These funds are aligned to a particular benchmark index such as the S&P CNX Nifty, BSE Sensex, or even for that matter a sectoral index such as BSE Bankex. The endeavour of these funds is to mirror the performance of the designated benchmark index, by investing only in the stocks of the index with the corresponding allocation or weightage. Hence, investing in index funds is less cumbersome as compared to investing in actively managed funds. Also they carry with them a low expense ratio along with a low risk (as compared to actively managed mutual funds), making market timing irrelevant. Low portfolio churning also adds to their merit. The fund manager in an index fund exits a certain stock only when a respective stock exits from the index and is replaced by another one.

Recently, it was highlighted how the legendary investor Warren Buffett's Berkshire Hathaway vastly outperformed the stock market during the last 49 years. In comparison, Berkshire's performance in the last 5 years has not been that exceptional. Thus, the article has stated this increased the attractiveness of index funds given that even an experienced investor like Buffett is not able to beat the market.

Does this mean that one should stop investing in actively managed funds and only invest in index funds? We do not think so. There is no hardcore proof which suggests that index funds always consistently perform better than actively managed funds. The Warren Buffett comparison only highlights the benefits of investing in index funds. But does not conclusively prove that they are the best performing of all mutual funds out there. Besides, many investors prefer diversity which an index fund, by its very nature, does not provide.

Ultimately, whether one chooses to invest in an index fund would depend on factors such as your investment objective, your risk taking ability, age and income profile among others. If you have enough risk taking ability and are willing to do your homework in terms of investing in good quality stocks at attractive prices, there is no reason why your portfolio should not deliver better returns than if you had put your money in index funds.

Would you rather invest in actively managed funds or index funds? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
While growth in the developed world has considerably stagnated since the 2008 global financial crisis, emerging countries such as China and India have seen their growth engines slow down in the last couple of years. No doubt growth in these countries is still way better than that of their developed counterparts. However, it will be a while before China and India are able to go back to those heady days in the past when they regularly logged in growth rates of 10% and 9% plus respectively. As can be seen in the chart, for most of the countries, barring China, growth is expected to be a tad better in 2015 than in 2014. China is expected to face some headwinds as exports (one of the economy's major growth driver) have slowed down on account of the weak global environment and because of the Chinese government's measures to put an end to widespread credit expansion and indiscriminate lending.

Will 2015 be a better year for the global economy?

While the from the Sun Pharma-Ranbaxy merger is still wet, the media is abuzz with articles about where possibly Ranbaxy's erstwhile parent Daiichi Sankyo might have gone wrong. It should be noted that the investment that the Japanese parent made in Ranbaxy has lost nearly 40% value in six years! So, can the blame be put on Indian pharma companies? Have they been perennial underperformers especially after they are acquired? We don't think so. Just as there is a Ranbaxy example about how messy things could become, there have been quite a few success stories as well. The fault therefore seems to lie elsewhere.

We believe that the price that Daiichi Sankyo paid for the company and a lack of proper due diligence about the management's real intentions could well be the prime reasons for the debacle. Now that the dust has settled, it seems to us that the management at Ranbaxy did not seem to mind cutting a few corners in order to become too big, too fast. And this came to haunt Daiichi Sankyo later on. So while there's very little that the company can do about it now, we hope this example serves as a reminder to other possible acquirers in the future about how worse things can get.

The days of never ending stimuli seem to have gone. And it is not just the US that is refraining from keeping the liquidity tap perpetually open. China too seems to be in agreement that large stimulus measures are no longer good for the economy. China's lagging growth has unnerved global investors. It has also fueled speculation about whether the government will yet again offer a stimulus package to stoke growth. It may be recalled that China unleashed several stimulus programs following the 2008 global financial crisis. But according to Moneynews, China's debt problems has had policymakers think against such measures this time around. The Chinese government may consider lowering taxes. However, those expecting a full fledged stimulus program could certainly get disappointed. We believe that faced with the prospect of debt crisis or hard landing, China will do well to adopt a middle approach.

Amidst the macro challenges, here comes the respite. As per a leading daily, the ratings agency Moody's believes Indian bank stocks are better placed to face global shocks. This is despite the trimming of the bond borrowing program by the US Federal Reserve. However there is a flipside too. Tapering exercise would result into higher interest rates, weakening the credit growth of the system. It would also imply reversal of capital flows from the Asian region. And if this were to happen, then upsurge in bad loans stand imminent.

Not just that! Negative financial market adjustments would also lead to mark-to-market losses on the banks' investment portfolios. To a certain extent the higher interest rates should aid the margins expansion for the banks, cites Moody's. Nonetheless the ratings agency believes that the expanding trade relations with developed economies would continue to augur well for the Indian banks. And strong earnings, limited foreign funding and healthy capital place Indian banks on a surer footing.

After a long wait, the BJP finally came up with its election manifesto yesterday. The saffron party which is known to be more business-friendly has promised to fight inflation, restore economic growth, solution for job crisis and initiate tax reforms. While these promises were welcome, there was one thing that didn't impress India Inc. In its manifesto, the BJP has maintained its opposition to FDI in multi-brand retail while showing openness to FDI in all those sectors that will create jobs. It must be recalled that the UPA government went head over heel to open up FDI in multi-brand retail, tooting it as the much-needed economic reform. But is this reform the one that will be a game changer for India? We don't think so. What India really needs is a better and more inclusive economic environment. So as far as the debate on multi-brand retail is concerned, the saffron party's stance is just that, a stance.

Indian tax laws are amongst the most complicated in the world. And when this is coupled with uncertainty and inconsistency, it only makes matters worse. As per the findings of a survey conducted by consultancy firm Deloitte, India is ranked amongst the most complex tax regimes in the Asia Pacific region. And this would be a key concern for investors because such matters significantly influence business decisions. As reported in the Economic Times, nearly 81% of the respondents of the survey were of the view that the tax regime in the country had become more complex. Further, over half of the respondents felt that the same has become less consistent in the past three years. A lot of this would have to do with some of the high profile retrospective tax cases that occurred in the recent past. Nevertheless, the government should consider the outcomes of this survey and bring about the necessary changes to make India a safe and more importantly consistent investment destination.

In the meanwhile, Indian stock markets were closed on account of Ram Navami. At the time of writing, the Asian stock markets were trading mixed. Chinese and Hong Kong stocks were the biggest gainers. The European markets opened on a lower note.

 Today's investing mantra
"Your life must focus on the maximization of objectivity." - Charlie Munger

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4 Responses to "Should you ignore Buffett and opt for index funds?"


Apr 14, 2014

Mr.Buffet has suggested index funds as one of the best for majority of investors.

In his recent advice to trustees managing his late wife's estate, he has suggested investing 90% funds in S&P 500 Index fund and another 10% in fixed income


maneesh konkar

Apr 12, 2014

Two global statements - totally incorrect!!!

"There is no hardcore proof which suggests that index funds always consistently perform better than actively managed funds."

Just check morning star or value research data over the last ten years or more for NAV growth in index over other mutual funds, you will get your answer.

"Besides, many investors prefer diversity which an index fund, by its very nature, does not provide.". The NIFTY - consists of 50 stocks across sir - how many sectors?? these are supposed to be the largest companies in multiple sectors. "an index fund" DOES NOT provide diversity? Get your facts straight sir.


Kirandeep Atwal

Apr 9, 2014

Markets are inefficient in long term. If you have capacity to stay invested in markets for more than 5 years then you can generate decent alpha.


Abhay Dixit

Apr 8, 2014

FDI flow does not depend on 100% ownership. It depends on good governance and simple tax and other laws. Look at Dubai, except for Export zones, each business has a local partner. Do they not get huge FDIs? CII, FICCI are weak and are not pushing right reasoning for stopping 100% FDIs. Their public relations (with Indian public) is also very pathetic. They need to go for more discussions on local language channels to convey their contribution to economy.

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