In India, we are used to the concept of professional fund management. Today, a host of mutual funds are available to investors. A unifying feature of all of these funds is that they are all actively managed funds -- fund managers select a portfolio of stocks so as to get "high returns".
An alternative approach towards fund management exists: that of a fund which is passively managed. Such funds are called index funds.
An index fund is a fund whose daily returns are the same as the daily returns obtained from an index. Thus, it is passively managed in the sense that an index fund manager invests in a portfolio which is exactly the same as the portfolio which makes up an index. For instance, the NSE-50 index (Nifty) is a market index which is made up of 50 companies.
A Nifty index fund has all its money invested in the Nifty fifty companies, held in the same weights of the companies which are held in the index.
It is hence obvious that an index fund can never "beat the index". On the other hand, it can also never do worse than the index. This type of fund management leaves no decisions open, about what companies to hold and how much to invest in each company.
This is contrary to active management, where a good fund manager is considered to be one who can invests a lot of resources into researching which are the companies to hold so that the returns on the managed portfolio is more than what the "market" offers.
Thus, index funds explicitly give up the biggest objective of every active fund manager, which is that of "beating the market". This sounds completely unlike the efforts of all fund managers in the country. Why would it be a good idea?
1. The simplest fact is that beating the market is hard. Two decades of study of evaluation of mutual funds suggest that most funds fail to beat the market, on a risk-adjusted basis. That is, when funds offer high returns, typically they are more risky than those which offer lower returns.
Results of this nature have been observed in a wide variety of markets, all over the world. In India also, the track record of funds at outperforming the market is dismal.
2. The behaviour of an actively managed fund fluctuates more than passively managed index funds. When funds do beat the market, on a risk-adjusted basis, it is often the case that this owes to good fortune, and the excess returns are not repeated in following years.
The problem of identifying a good fund manager is as hard as picking good stocks. Matters are made worse by the fact that the performance of fund managers fluctuates with changes of the management team that runs a fund changes.
The behaviour of the market index, in comparison, is more predictable -- it has a more reliable risk-return tradeoff. You know more about what the volatility of Nifty is going to be next month, based on past experience, as compared with the volatility of a fund NAV (which could change for a variety of reasons).
3. There is an additional issue of management fees. Active managers incur various expenses: wages for research and fund management staff, costs of buying data and computer power, and transactions costs in trading. Ultimately, investors who buy into these funds are paying these costs. In contrast, Index funds avoid almost all these costs.
The above set of points seems to suggest a strong case for index funds. But an argument can be made that different investors have different needs.
A young person, at the start of her career, might be willing to make a more risky investment for higher returns compared to a retired person, who would not be as willing to accept so much risk in her investment and would settle for a lower amount of returns. In this case, portfolios need to be tuned to specific situations.
If a rich person can afford to hire a personal fund manager, wouldn't the personal fund manager do something unique that addresses his needs? In this sense, don't we need something more than just holding the index?
A well-researched body of financial economics suggest that there are exactly two assets that are important: the riskless asset (like money in the bank, or government treasury bills) and the market index. Any investor can choose an acceptable level of return and risk by mixing these two in varying proportions.
Low risk portfolios can be constructed by putting a smaller fraction of money into the market index. Risk greater than the market index can be obtained by borrowing at the riskless rate and investing in the market index.
Hence, we only need two funds -- a riskless investment and an index fund -- to take care of the investment objectives of everyone.
Index funds are available from many investment managers. Some common indices include the S&P 500, the Wilshire 5000, the FTSE 100 and the FTSE All-Share Index.
An alternative approach towards fund management exists: that of a fund which is passively managed. Such funds are called index funds.
An index fund is a fund whose daily returns are the same as the daily returns obtained from an index. Thus, it is passively managed in the sense that an index fund manager invests in a portfolio which is exactly the same as the portfolio which makes up an index. For instance, the NSE-50 index (Nifty) is a market index which is made up of 50 companies.
A Nifty index fund has all its money invested in the Nifty fifty companies, held in the same weights of the companies which are held in the index.
It is hence obvious that an index fund can never "beat the index". On the other hand, it can also never do worse than the index. This type of fund management leaves no decisions open, about what companies to hold and how much to invest in each company.
This is contrary to active management, where a good fund manager is considered to be one who can invests a lot of resources into researching which are the companies to hold so that the returns on the managed portfolio is more than what the "market" offers.
Thus, index funds explicitly give up the biggest objective of every active fund manager, which is that of "beating the market". This sounds completely unlike the efforts of all fund managers in the country. Why would it be a good idea?
1. The simplest fact is that beating the market is hard. Two decades of study of evaluation of mutual funds suggest that most funds fail to beat the market, on a risk-adjusted basis. That is, when funds offer high returns, typically they are more risky than those which offer lower returns.
Results of this nature have been observed in a wide variety of markets, all over the world. In India also, the track record of funds at outperforming the market is dismal.
2. The behaviour of an actively managed fund fluctuates more than passively managed index funds. When funds do beat the market, on a risk-adjusted basis, it is often the case that this owes to good fortune, and the excess returns are not repeated in following years.
The problem of identifying a good fund manager is as hard as picking good stocks. Matters are made worse by the fact that the performance of fund managers fluctuates with changes of the management team that runs a fund changes.
The behaviour of the market index, in comparison, is more predictable -- it has a more reliable risk-return tradeoff. You know more about what the volatility of Nifty is going to be next month, based on past experience, as compared with the volatility of a fund NAV (which could change for a variety of reasons).
3. There is an additional issue of management fees. Active managers incur various expenses: wages for research and fund management staff, costs of buying data and computer power, and transactions costs in trading. Ultimately, investors who buy into these funds are paying these costs. In contrast, Index funds avoid almost all these costs.
The above set of points seems to suggest a strong case for index funds. But an argument can be made that different investors have different needs.
A young person, at the start of her career, might be willing to make a more risky investment for higher returns compared to a retired person, who would not be as willing to accept so much risk in her investment and would settle for a lower amount of returns. In this case, portfolios need to be tuned to specific situations.
If a rich person can afford to hire a personal fund manager, wouldn't the personal fund manager do something unique that addresses his needs? In this sense, don't we need something more than just holding the index?
A well-researched body of financial economics suggest that there are exactly two assets that are important: the riskless asset (like money in the bank, or government treasury bills) and the market index. Any investor can choose an acceptable level of return and risk by mixing these two in varying proportions.
Low risk portfolios can be constructed by putting a smaller fraction of money into the market index. Risk greater than the market index can be obtained by borrowing at the riskless rate and investing in the market index.
Hence, we only need two funds -- a riskless investment and an index fund -- to take care of the investment objectives of everyone.
Index funds are available from many investment managers. Some common indices include the S&P 500, the Wilshire 5000, the FTSE 100 and the FTSE All-Share Index.