Should you invest in Index Funds?

Introduction

The merits of investing in index funds have been argued by stalwarts like John Bogle of Vanguard Group and Warren Buffett of Berkshire Hathway. Interestingly, Buffett himself never invested in index funds. So should you, the small investor, invest in index funds? In this post we try to explore.

Beating the Street

In our previous article, we had discussed about the benefits of investing in equities over long term. We saw studies conducted in the US, as well as our own results in India, which establishes unequivocally that over long term, returns in equities outperforms any other asset class by a wide margin.  One rupee invested in Sensex, Gold and FD in 1981, would have grown to become Rs 221.72 today, as opposed to Rs 25.6 in Gold and 29.06 in FD (without adjusting for inflation and taxes)

Knowing that equities are the asset class of choice for long term investment, question is, how can we improve our returns further? After all, our study merely invested the rupee in the BSE Sensex stocks, which in essence is a ‘passive’ investment strategy, as it requires no research other than knowing the composition of the BSE Sensex.

In reality, there are multiple ways to beat the index consistently over long-term. In this article we will explore just a few. But before we do that, let’s take one step back and understand what investing in the index really means.

Index as a Momentum Strategy

If we consider market index as an investment strategy, then equity indices around the world in most cases resemble long term momentum strategies of some sort. The BSE Sensex for example, is constituted by picking large cap companies with high liquidity (along with certain other criteria). Constituents are weighted by market cap, which in essence means systematically buying stocks that have gone up, and selling those that are out of favour. Does this sound like a good investment strategy? You might already be having your doubts.

Of course market indexes are not constituted to provide high return investment strategies, rather they provide indication of overall market performance, for which purpose market cap weighted strategy makes perfect sense.

Problem is, investment advisers, and often legendary investors promote investing in the index, for entirely different reasons, when in reality, for the small investors it’s a poor investment strategy that is fairly easy to outperform. Consider the following simple tweak for example.

Equally Weighted Index

We make a simple adjustment to the index constitution. Instead of weighing the constituents by market cap, we weigh them equally, i.e. instead of buying more of what is going up and selling declining stocks, we hold equal quantities of each stock by value. Using NIFTY-50 as the base index, starting 03-Nov-1995 till date, for past 24 years the results are as follows in Fig-1. After initial few years of neck-to-neck performance, the market cap weighted index never really manages catch-up with the equal weighted index.

equally weighted index funds vs price weighted index

Fig-1, Source: NSE, B. Sinha Ray Research & Advisory

Benchmarking Randomness

Andreas Clenow in his interesting book ‘Stocks on the move: beating the market with hedge fund momentum strategies’ performed a rather unique study. He let computer pick stocks from S&P 500 at random. At the beginning of each month, the entire portfolio is liquidated and 50 random stocks are bought in equal proportions. Simulation was repeated a few hundred times and the results were fairly consistent. Apparently, not a single simulation failed to beat the index.

random index funds

Fig-2, Source: ‘Stocks on the move: beating the market with hedge fund momentum strategies’ by Andreas Clenow, pp 265

Conclusion

The above results removes any remaining shade of doubt that market cap weighted indices or index funds may not be the best strategy for producing high returns. In the US, S&P 500 Equally Weighted Index was introduced in 2003. Back home, NSE introduced NIFY-50 Equally Weighted Index as recently as April 2017. BSE is yet to include this strategy in its basket of indices.

Now for the best part. Given all this, it might appear that beating the index is ridiculously simple, and the highly paid Fund Managers working for AMCs managing Mutual Funds must be beating the pants out of the indices by a wide margin day in and day out. Well… at least if we look at objective data available for the US market, in any given year Mutual Funds that fail to beat the index over a 5 year period range anywhere between 60-80% or more! So much for the smart money!!

This is a very interesting paradox, and the reasons include management fees, herd mentality of Fund Managers, among others. We will explore it, along with what it means for the individual investors, perhaps in another post.

Reference

  1. National Stock Exchange

 

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