Disproving Arguments Against Index Investing - I : Basic Misconceptions

Indian investors are a lot more aware of the concept and benefits of index investing today. But there are still a number of arguments that they make against index investing. Some of these arguments are born from an improper understanding of mutual fund construction and performance. Others are born from misconceptions about the concept of index investing. Over the course of this post and the next I will touch upon the most important of these arguments and disprove them. I will do so on the back of logical explanations against each argument. I will also use data to support my explanations wherever necessary.

Indices Include Low Quality Stocks

Indexing is based on the concept of Free Float Market Capitalisation. It is arrived at by multiplying the market price of a stock with the prevailing number of shares available to be traded publicly. A broad market index holds all stocks within a particular segment of the market based on free float market capitalisation. The math behind indexing works only when this is done. Indices are agnostic to the quality of the stocks within them. Therefore inclusion of low quality stocks in the index is a matter of design. It is not a flaw of indexing.

Also, the term quality is subjective in nature. The stock of a good company available at an exorbitant valuation makes it a low quality investment. Likewise, the stock of a bad company available at a dirt cheap valuation would be a high quality investment. An index portfolio is a mix of underperforming stocks and consistent wealth creators. Active investors may miss out on some or all of the wealth creators. Index investors miss out on none of them.

Invest Directly In Stocks Through A Discount Broker

Some may argue for the benefits of holding stocks directly through a discount broker like Zerodha. But there are a few things to consider here. It is impossible to accurately predict which stocks would be outperformers during our investment horizon. This is because it requires us to accurately predict the behaviour and performance of the market. The market is essentially a group of investors coming together to buy and sell stocks. Therefore market performance is simply a reflection of investor behaviour at large. Predicting market performance therefore requires us to understand and predict human behaviour. And this impossible for any of us to do.

Most stocks in an index portfolio pay dividends. When stocks are held directly, these dividends are taxed at applicable slab rates. This creates an additional tax liability for investors. So what is saved in brokerage is eaten by taxes. In case of index funds dividends are automatically reinvested. So the additional tax liability is avoided. It also allows investors to capture the total return (price + dividends) of the index.

Index Funds Do Not Offer Downside Protection

This is true to some extent because index funds mimic the performance of the index, even on the downside. But it is also erroneous to believe that actively managed funds offer downside protection. Most actively managed funds experience drops that are worse than the index. And it is extremely difficult to identify the few that don't in advance. So achieving downside protection through actively managed mutual funds is extremely challenging.

It is important to remember that index funds are a tool used when following the defensive approach of investing. Under the defensive approach, portfolio risk is managed at the asset allocation level. This means risk is managed by regulating the allocations to equity and debt in the portfolio. Downside protection is therefore facilitated at the inter asset class level rather than the intra asset class level. This is a much more reliable way to achieve downside protection.

Index Funds Work In America, But Not In India

This is the mother of all misconceptions about index investing. It is akin to saying basic mathematical operations work in America but not in India. The basic math underlying index investing remains true across the world. It states that before taxes and costs, the average actively managed portfolio would earn the same return as an index portfolio. This is because the portfolios of market cap weighted index funds are such that the weightage of each stock in them is the same as that of the portfolios of all active investors in that segment. When the weightage is the same, the return also must be the same.

But taxes and costs associated with investing have a decisive impact on the net return earned by investors. Therefore after taxes and costs the average actively managed portfolio is guaranteed to underperform the index portfolio. This is a matter of mathematical fact that remains universally true.

I will release a blog post detailing the basic math behind index investing in the near future. This week's post focused on arguments born from basic misconceptions about the concept of index investing. Next week's post will focus on arguments against index investing born from an incorrect understanding of how index funds work.