»The Honest Truth by Ajit Dayal

Use Index funds for speculation, not for investment

The great thing about a democracy is that everyone has a right to air their views. The wonderful thing about having a free press is that they are free to carry all kinds of views and information and present it to readers and - in the case of the breathless TV channels - to viewers.

But, as discerning readers, it is up to us to know what is worth believing and what is, well, to be politely filed away.

On November 21, the Economic Times had this screaming headline, "Go for index funds, say bye to poor returns" which began with this really stylish paragraph: Advocates of index funds are grinning, and they have a solid reason in the form of the S&P CRISIL SPIVA - Indices Versus Active Funds Scorecard for June. According to the report, 53.62% diversified equity funds tracking S&P CNX 500 equity index failed to beat the benchmark index in the past one year. This underscores that most fund managers fail to beat the relevant indices consistently.---------------- Revised And Updated Edition Of "Multibagger Stock Ideas" ----------------

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Index funds are good for your health?

I love this debate over Index (or Passive) funds and Active funds. Index funds, the theory goes, are great places to invest because the fund manager has merely to replicate the Index every day. He does not need a team of research analysts and does not need to worry about future earnings. The markets have "perfect" information and the share price at any point in time reflects all that there is to know about a stock. There is no advantage in researching stocks. All that needs to be done is to mirror the index. And a simple Microsoft xl sheet can do that.

The Active Fund Managers, as the article suggest, wring their hands in worry and frown at their xl sheets as they try to understand and predict what will happen in the future. And after all their worry and all their research - and their higher management fees which are eventually borne by the investors - these active fund managers generally tend not to beat the Index.

So, the above article taunts that 53.62% diversified equity funds failed to beat the benchmark index in the past one year. The unwritten, unpublished, unfinished sentence is silently suggesting that investors may as well go out and line those useless 53.62% of fund managers against a wall and send the troops from Syria to finish the job.

Who sold you the duds? And why?

But before the investors do that, a few questions need to be answered:

  • Why would any investor buy equity mutual funds for a 1-year time horizon?
  • How did those actively managed funds do over longer time periods? Like 3 years, 5 years, and 10 years?
  • And who, in the first instance, recommended those useless 53.62% of funds?
Firstly, anyone buying diversified equity mutual funds for a one-year time horizon needs a seriously long 3-year course in financial literacy. This would mean ensuring that the censors prevent these investors from listening to much of what is spoken on the business TV channels and much of what is written about in the press.

Secondly, I don't know what the data says about how many fund managers beat their respective bench marks over the longer time periods but there must be some: the 100% less the 53.62% = 46.38% beat the Index over one year.

And it is for the investor to read that data in the magazines, newspapers, and websites and then migrate their savings to the winners and leave the losers. Actually, investors would do that in a free world. But, whether you like it or not, we don't live in a lethargic and captive world. Which leads to the third point: how did the funds that are not doing well over a longer period of time (5 years or 10 years) become popular and how come they still have investors' savings in them?

Let's start with the press: how many people in the press really write articles that reflect the truth? Or do they write sponsorship stories? When the press presents awards to the High and the Mighty Mutual Funds, do they rank them for their returns, the risk taken for the returns, or for the ad money that the fund houses can spend? Or a combination of all - and if a combination, what is the importance and weight given to each criterion?

Similarly, when the press quotes various fund managers do they quote those fund houses that spend more on advertisements or do they quote those who have something sensible to say?

Along with the press, we have some questions for the distribution channels. Cafe Mutual, in an article on November 18, based on AMFI data reported that the distributors earned Rs 1,800 crore in commissions for the year ending March 31, 2011. The top 10 banks and National Distributors earned 57% of this total.

Table 1: Selling the good stuff.
BanksRs crPercentage of Total Industry Commission
HDFC Bank1166%
Standard Chartered Bank774%
Kotak Mahindra Bank483%
Axis Bank442%
SBI Bank382%
ICICI Bank352%
The Royal Bank of Scotland N V322%
Deutsche Bank AG292%
Total Bank Commission62635%
National Distributors/Brokers   
NJ IndiaInvest Pvt Ltd1106%
JM Financial Service493%
Bajaj Capital382%
Aditya Birla Money Mart Ltd 372%
DSP Merrill Lynch Limited362%
SPA Capital Services332%
Karvy Stock Broking Limited322%
ICICI Securities Limited312%
Prudent Corporate Advisory Services Ltd211%
BNP Paribas20  
Total ND/Brokers Commission40723%
Total commission earned by top 10 Banks and NDs 1,033 57%
Total Industry Commission 1,800  
Source: Cafe Mutual, based on AMFI data

Getting paid by you - without your knowing it!

Not bad for a year's work. The question to be asked is: how much of distribution fees were earned for putting clients' savings in funds that have not outperformed their respective benchmarks over longer time periods like 5 years or 10 years?

So, between the power of the distribution channels and the write-ups of the press, are the investors are being guided into certain mutual funds? And being made to avoid certain funds because those fund houses don't pay distribution fees? Nothing wrong with this "selective selling", provided the data shows that the advice does lead to the investor being in the "winning 46.28%" of funds. And not in the "losing 53.62%" - of course based on long term performance and not 1-year returns!

And I will end with this thought: while it is true that 30% or 40% or 50% of the actively managed funds do not beat the benchmarks, guess what: 100% of Index funds HAVE to underperform their benchmarks in the long run.

And if they do not, then they are doing something funny!

100% of index funds will underperform their benchmarks in the long run.

Why must 100% of Index funds underperform the benchmark over longer term time horizons?

One point to note before we move further: The true benchmark is one that adds the dividends, rights, bonuses that we get as being shareholders. So there is the BSE-30 Index (which does not look at the value of such benefits of dividends being reinvested) and there is the BSE-30 Total Return Index (BSE-30 TRI). Many fund managers "cheat" by using the naked index when what they should benchmark against is this Total Return Index.

Well, the people who build the Indices change the stocks in the Index very frequently (Table 2). And when they change the stocks that are in - or out - of the Index, this causes the composition of the Index to change. And the index fund has to mirror that change - unless they wish to cheat and not mirror the Index. In which case they are a "closet active fund manager" and could be part of the poorly performing 53.62%!

Table 2: The number of changes in the indices every year leads to high costs for a true index fund
No. of scrip replacedCY 2000CY 2001CY 2002CY 2003CY 2004CY 2005CY 2006CY 2007CY 2008CY 2009CY 2010YTD 2011
Source: www.bseindia.com; www.nseindia.com; As of October 31, 2011

Let's say that Zee was taken out of an Index and Sun Pharma was brought in. Let's assume that Zee's weight in a 100-stock Index was, say, 5% - this means that the weight of other 99 stocks is 95%. Similarly, let's assume that market cap of the new, in-coming stock of Sun Pharma gives Sun a weight of 10%; this means the weight of the other 99 stocks in a new (Sun Pharma inclusive) 100-stock Index should be 90%.

But, when Zee was there your Index fund had Rs 95 in those 99 stocks and Rs 5 in Zee. Now it needs to have Rs 90 in those 99 stocks that have not changed and Rs 10 in Sun Pharma. It sells Zee (that is the outgoing stock) and gets Rs 5 cash. To buy Sun Pharma it needs Rs 10. But it has only Rs 5 from the sale of Zee. So, to pay for that extra Rs 5 to buy the matching amount of stock in Sun Pharma, the fund manager needs to sell 99 other stocks in such a proportionate way that he generates that extra free cash of Rs 5 to pay for the Sun Pharma stock.

Selling 99 stocks costs money. There is the brokerage and the STT. By paying these expenses, the fund manager has less money to invest in shares. On top of that there are the annual fees and costs of running an Index fund. The underlying benchmark index managed by a stock exchange does not pay management fees, custodian fees, trustee fees, brokerage fees, or STT.

So every time there is a change in the composition of the Index, a true index fund would increase its costs. And have less money invested in the market. And since there can be many changes in any index in any year, that is a lot of costs.

Therefore, over time, the value of the index fund will no longer mirror the underlying Index. It will tend to be less - unless the fund manager starts taking bets against the index - in which case this is no longer an index fund!

Therefore, 100% of Index funds, over time, have to underperform the indices in India.

Ask the question!

But there is a place for an Index fund in your portfolio. Let's say the stock market falls 20% because the Eurozone goes bust. And you "feel good" about a rebound in a short time. If you wish to allocate an "extra" 5% or 10% into the stock market to speculate, go ahead and buy an Index fund. And then sell out of the index fund when you think you got your ride and reached your "target"!

That's not the sort of investment philosophy I recommend but some people like to roll the dice!

But, for long term investors in an Indian environment - where indices change the underlying companies in the Index very often - an Index fund is putting money into an "underperformer".

To identify the winners, though, will require you to have a good financial advisor and arm yourself with a newspaper or magazine that has data on long term performance. This will allow you to ask pointed questions. Since investors in mutual funds like you paid Rs 1,800 crore as distribution fees last year - it is your birth right to know why you were sold certain funds.

Or, in the case of the Quantum Mutual Funds, you may have to ask another question: Why you were not offered the Quantum mutual funds!

Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
Quantum Liquid Fund
Why you
should own
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.