Index Investing - Simplified

Introduction

It is a physiologically proving theory that when we face multiple choices, we as humans, always struggle to choose the right option or what’s best for us. So what we end up with is stress and problematize decision making. Barry Schwartz - The Paradox of Choice has well explained this in the book - ''Why More is Less.''

The same is true for the world of Investing. We as investors have so many options and choices at our disposal, that we cannot understand what is best for us or rather what suits us or better yet, what we need. The chances are, as a layperson, without professional help, we would make a wrong decision. If I have to put this into some number game, then so to say, we have around about 45 mutual fund houses in India offering over 2500 mutual fund schemes across various categories. Piece of cake for someone to decide, isn’t it? 

The Paradox of Choice will ensure that most of us do not even start with Investing. It’s a very tuned out saying in the world of Investing, that, ‘Investing is 10 percent versus 90 percent psychology’. As an investor, it all about your psychology to stay invested throughout your journey to achieve your goal.

This is where the role of Active v/s Passive choice comes into the picture. Let me touch upon these 2 topics subtly so that we realize what these concepts hold for us.

Active v/s Passive choice

Active is when the portfolio manager invests your money in a certain way basis his analysis of the market, the economy, and so on, the micro and macro parameters. So basically it means he buys and sells stocks actively, with a view of making higher returns. The success of an actively managed fund depends on combining in-depth research, market forecasting, and the experience and expertise of the portfolio manager.

Passive is when the fund manager does not decide on his own but just invests in an Index. So what is an Index? In simple words, it is nothing but a list of stocks assembled based on a certain set of rules. For example, for simplicity’s sake, let's say that NIFTY50 is nothing but top 50 companies by market value on NIFTY. So when a fund manager is running a passive scheme, all that he is doing is buying the stocks in NIFTY50 in the same proportion. If there is a change in NIFTY50, the fund manager will automatically change his portfolio to match the Index.

So let's get to the point. Why should one choose one over the other? it’s rather very simple. Let me put this in food. Active Funds are more like your fast food, whereas Passive Funds are more like Dhal Chawal or Roti Sabji. So, if you ask my view, I always state that if you are starting off investing or if you have limited money, you should first always build your portfolio with Passive funds. Once you have done so, you could always venture out and start selecting Active Funds.

For years, the so-called Oracle of Omaha has championed index funds. He even instructed the trustee who will be in charge of his estate to invest 90% of Buffett’s money into these assets for his widow. That is S&P 500 Index. A passively managed fund by Vanguard.

Advantages:

 There are multiple advantages to invest in an Index. Here are some of them:

1. As we are aware, Index investing is all about a passive strategy, which helps the investor just invest in the same proportion as the Index (of course there is called a tracking error, but I shall explain that in a bit). So your portfolio moves in tandem with the Index. If the index gains 10% so does your portfolio, and if the index drops 10%, so does your portfolio.
2. These are low-cost styles of investing. The expense ratio (the amount of money you would pay the fund manager to manage your money) is lower for these funds as compared to the Active counterparts. This gives them a significant advantage over the long run.
3. Index investing suits really well for a new investor or a DIY (Do it Yourself) investor. Generally speaking, a Financial Planner would also advise you to have Index Investing at the heart of your portfolio before you dive into any other options.
4. As an investor, you could start with an amount as low as Rs. 500 SIP which gives you a significant advantage to start small, feel the beat, and then grow large.
5. Index investing allows you to take advantage of a diversified portfolio. Here is a small look at how NIFTY50 has spanned out over the years. What this simply means that your Rs. 500 is diversified into the below sectors in the proportion mentioned below by buying the stocks of the Top companies.  

Disadvantages:

Have spoken about the advantages, there are a few disadvantages also of Index Investing. Now I would not want you to be aware of only the bright side, neglecting the other side. So here are some disadvantages:

1. Since the style of investing is just to copy the index, the chances of beating the index are negligible. So we should earn only what the index earns (keeping aside the tracking error).
2. Active funds are better suited if you want to run long on Mid Size or Small Size organizations. The reason is simple, the Fund Manager can use his team and the rich data at his disposal to select companies that would be the future leaders. Of course, Risk and Reward go hand in hand. So yes, Index Investing is low risk, along with low risk, comes low reward as compared to Active style of selecting Mid and Small size companies.
3. As Index funds aim to reflect index and reduce the tracking error, they won’t be acting proactively for any inclusions or omissions to the index. For example, if a stock has met the set criteria for being included in the index it would start gaining momentum days before it becomes part of the index and index funds won’t be investing in these funds proactively, losing out on the run or buying at a high cost.
4. If you are keen on professional advice, or know a lot about how to go about investing, then active choice funds (if selected prudently) can help you earn a slightly higher return (called the alpha). So yes, Index investing is all about letting go of this alpha when we are buying into the market. Over a long period, this could be quite a sizeable amount. See the below example. However, please do not get carried away by this. There is also an equal chance, if not more, for the Active funds not to even perform at 12% which are the rolling returns provided by NIFTY50 over the last 15/20 years.

Here is a quick note on what is a tracking error. Tracking error is nothing but a difference between the Funds Performance versus the index that it tracks. So, for example, if the Funds performance is 12% whereas the Index has performed at 12.35%, we attribute this to the tracking error. This is a critical aspect for a Passive Fund. You would not want to select a fund that has a high tracking error. It would simply mean that the fund cannot track its Index efficiently. 

So now that we are clear with what’s Active versus what is Passive, it’s time for us to understand a few instruments that help us dive into the world of the Passive style of investing.

1. Exchange-Traded Fund (ETF): ETF's are instruments that pool the financial resources of several people (just like a Mutual Fund) and use it to purchase various tradable monetary assets such as shares, debt securities such as bonds.
2. Index Mutual Funds: As the name suggests, an Index Mutual Fund invests in stocks that imitate a stock market index like the NSE Nifty 50, BSE Sensex 30, etc. 

 Here is a simple table that will help explain the difference between the two:

Conclusion:

I hope I could help explain Index Investing in a nutshell. If you did like my write up, please leave a comment in the section below. Any topic which you would like me to take up next, please mention. I am always happy to learn and pass on the information as much as I can to others.