There are index funds and Exchange Traded Funds that mimic the index. Buying them, we are assured of ‘market returns’.
It is useful to talk about the Sensex and the Nifty and measure the performance of portfolios in comparison to these indexes. Let me dig up what companies formed the Sensex when it was first presented.
Asian Cables, Indian Organic Chemicals, Ballarpur Industries, Indian Rayon Industries, Bombay Burmah Petroleum, ITC Ltd, Ceat Tyres, Kirloskar Cummins Ltd, Century Textiles, L&T, Crompton Greaves, M&M, Glaxo, Scindia Steamship, Mukand Steel, Gwalior Rayon, Nestle, GSFC, Hindustan Motors, Siemens, Hindustan Lever, Hindustan Aluminum, Tata Iron & Steel, Tata Motors, Zenith Ltd, Indian Hotels, Premier Automobiles, Tata Electric, ICI, Kirloskar Oil Engines (Note: these are from memory).
When it started, financials were zero. And looking at the list, the survivors are just around one third. The index has changed its industry representation beyond recognition. Today, the index is packed with financials. The finance sector represents nearly forty per cent of the Sensex! And my understanding is that if we slice our GDP, the finance sector does not contribute more than 15 per cent to our GDP. BSE has its criteria for inclusion and exclusion of companies in the Index. In a sense, the index itself is very active! Talk about ‘passive’ investing!
Index returns need not be representative of the economy or the stock market. Each of us will have a different portfolio. A single stock like Reliance may form more than ten per cent of the economy.
So what do we aim for as an investor? People tell me that if chosen carefully, we should be able to ‘beat’ the index easily. Please have a look at mutual funds. If some of them cannot beat the index, what are our chances? Mutual funds have experts who spend 24/7 looking at stocks and investment.
There are index funds and Exchange Traded Funds that mimic the index. Buying them, we are assured of ‘market returns’. Doing it on our own, our odds of beating the index is less than 50 per cent. I am stating this from observations and experience.
The other way is to look at what are absolute returns that we should expect from stocks? Is there an answer? Let us try. If industry grows at 10 per cent and inflation is five per cent, then the nominal growth should be 15 per cent average. So depending on the stocks that we pick, we could be either above average or below average. One way to improve our odds is to focus on ROE or ROCE and choose the more profitable companies.
Now, our selection will deliver on profits. The big question is, will it deliver on share prices? Did we buy the stock at the right price? If we did and the market behaved rationally, we have beaten the market. We have no control over the prices.
Buying the Index as a basket is something to be considered as a safety mechanism. In this, we ride the ups and the downs. In a year we may get spectacular returns and in another year we may get lousy returns. A table on the Sensex returns is provided above.
As we see the returns do not come through in an orderly fashion. And in an index, there is a lot of averaging out. There is some sector rotational performance which finally results in to a total index return. I believe that there is a lot of sense in index investing. Especially if we using an SIP route, since we will be buying at varying levels of the index.
Of course, we cannot then enjoy the thrills of ‘stock-picking’. I would adopt the index SIP approach if I am not a very rich person and am building my first bundle of wealth. For those who have enough to spare, there are no constraints.
The index, however much one may dislike it or say is not representative of the economy, gives returns that most mutual funds find hard to match.
The other important thing to keep in mind is that as funds grow larger in size, they are compelled to invest in the biggest stocks. They may just play around with the index stocks by varying the ‘weights’ in their fund. However, our Index is generally driven by a half a dozen or so stocks that give most of the returns to the index. If the mutual fund has more of those stocks, they beat the index. If not, they lag. So, there is risk of underperformance by not mimicking the index.
Index investing is peaceful. If we believe that the economy will grow and so will companies and share prices. The index composition is a dynamic one and leaves behind duds and keeps adding the new new things. And I will not time the index. An SIP approach is what I can suggest. And my preferred vehicle is an ETF rather than an Index Fund.
(The writer is a veteran investment adviser. He can be contacted at firstname.lastname@example.org)