Misconceptions about index investing you should ignore!

Published: July 19, 2023 at 6:00 am

In this article, SEBI-registered flat fee-only investment advisor, Swapnil Kendhe, addresses common misconceptions about index investing that passive investors should ignore.

About the author: Swapnil is a SEBI Registered Investment Advisor and is one of the sought-after advisors on the freefincal fee-only financial planners’ list. You can learn more about him and his service via his website, Vivektaru. His story: Becoming a competent & capable financial advisor: My journey so far.

As a regular contributor here, he is a familiar name to regular readers. His approach to risk and returns are similar to mine, and I love the fact that he continually pushes himself  to become better, as you see from his articles:

“The BS asymmetry: The amount of energy needed to refute bs is an order of magnitude bigger than to produce it.” – Alberto Brandolini

Only a tiny section of the investor community understands indexing. It is, therefore, easy to criticize indexing by saying things that intuitively appear right but are plain wrong.

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Any criticism of indexing also gets validation from others who are equally ignorant of indexing. Critics of indexing, therefore, keep believing they understand it when they don’t.

Here are a few misconceptions about index funds many influential people in the personal finance space hold and propagate.

1. Quality is completely out of the dimension of selection in indexing. All kinds of companies are included in the indices.

 “Don’t look for the needle in the haystack; just buy the haystack.”

This quote by John Bogle perfectly describes what indexing is. Index Funds hold all stocks available in a segment of the market being indexed in the proportion of their free-float market capitalization. The arithmetic that indexing is based on works only when you do that. Therefore, the perceived bad stocks being part of the index is a design, not a bug.

‘Quality’ is also subjective. Whether a stock was good or bad becomes clear only after the fact. A stock of a good company available at a super expensive valuation could be a bad stock. Likewise, the stock of a bad company available at a dirt-cheap valuation could be a good stock. Index doesn’t make any judgments about the quality of underlying companies in the portfolio.

Index holds all the underperforming stocks in a segment of the market; but it also holds all stocks which create massive wealth for investors. Active investors routinely miss some of the greatest wealth-creation opportunities. Index investors don’t miss any.

2. Index Funds buy more when prices rise and sell when prices fall.

Index funds automatically track the index as prices change. No trading is required except when some index components are added/deleted and when there are corporate actions like issuance of additional shares, buybacks, mergers, demergers, acquisitions, etc. This point is counter-intuitive, but let me try to explain it using an example.

Suppose we construct an index of only two stocks; Kotak Mahindra Bank and Axis Bank. For the simplicity of discussion, let us assume that the free float market capitalization of both these companies is the same. So, if we invest ₹100 in this index, we will have to purchase ₹50 of Kotak Mahindra Bank and ₹50 of Axis Bank.

Kotak Mahindra Bank5050%
Axis Bank5050%

Suppose the price of Kotak Mahindra Bank stock goes up by 20% and Axis Bank stock goes up by 10%. The portfolio would now look like below.

Kotak Mahindra Bank6052%
Axis Bank5548%

We did not change anything in the portfolio. But now 52% of the portfolio is in Kotak Mahindra Bank and 48% is in Axis Bank. The free float market capitalizations of both these companies have also changed in the same proportion. The weightage of both these companies got auto-adjusted as per the new weightage in the index. No forced buying or selling was required. If we invest another ₹100 in this index, ₹52 will now be invested in Kotak Mahindra Bank and ₹48 will be invested in Axis Bank.

This is why indexing is called passive investing. All the fund manager needs to do is invest in proportion of the free float on the day he receives new money. He doesn’t have to buy more shares of stocks whose weightage increases in the index or sell shares of stocks whose weightage reduces in the index.

3. Index Funds buy more stocks of the companies having higher weightage in the index thereby distorting their prices compared to other components in the index.

 This is not how indexing works. If the total free float market capitalization of Nifty 50 companies is 100,00,000 crore, and the size of a Nifty 50 index fund is 10,000 crore, this fund will hold 10,000/100,00,000, i.e. 1/1000 of the free float shares of each stock in the index. If the fund gets an additional 10 crore investment, the fund will purchase 10/100,00,000, i.e.1/10,00,000 of the free float shares of each stock in the index.

If, owing to an increase in price of a particular stock in the index, the total free float market capitalization of the Nifty 50 Index increases to 102,00,000 crore, the index fund will do nothing. If the fund gets additional 10 crore investments in the fund, the fund will now purchase 10/102,00,000 i.e.,1/10,20,000 of the free float shares of each stock in the index.

Index funds hold and purchase the same percentage of free float shares of each component stock in the index. Therefore, the effect of index funds buying into the market, on the prices of stocks having a higher weightage in the index, would not be higher than its effect on other stocks in the index.

 4. The return you get in the Nifty or Sensex Index Fund would be the same as the return of Nifty or Sensex.

 Most companies in an index fund portfolio pay dividends. When an index fund receives this dividend, it is reinvested in the portfolio. Nifty or Sensex are price return indices. They do not reflect the effect of dividend reinvestment that happens in the index fund. Therefore, the return that a Nifty or Sensex Index Fund generates is higher than the return of Nifty or Sensex.

5. Why invest in an index fund and pay an annual expense ratio when you can invest directly in stocks in the index through Zerodha at zero cost?

 This is a bad idea. When you hold stocks directly, you pay tax on the dividend as per your tax bracket. But when the same dividend is received by a mutual fund scheme, it doesn’t have to pay any tax. All the dividend income is reinvested in the portfolio. Semi-annual rebalancing of the index would also attract tax liability, unlike in an index fund which doesn’t have to pay tax on the realized gains. So more than what is saved in the expense ratio would be lost to the tax.

There is another problem. The portfolio size of most investors is not big enough that every dividend payment can be invested back in 50 stocks that a Nifty Index holds. There will be a massive tracking difference if you try to mimic an index in your zerodha account.

6. When so many actively managed funds beat the index, what is the need to invest in index funds?

There will always be funds that have beaten the index in the past. But the game is not to find winning funds of the past, but to find funds, in advance, that will beat the index between two dates an investor will stay invested in them. Only a minority of active funds beat the index and there is no reliable way to find these funds in advance.

Most investors and advisors who believe they can find winning funds of the future by studying past data miss a simple but important point. To predict the future performance of any system based on its past performance, the behavior of that system must be consistent. Actively managed funds are managed by fund managers, who are human beings like you and me. The behavior of no human being is consistent. When your behavior is inconsistent, you become unpredictable.

Therefore, no matter what an investor or an advisor does, the fund selection remains a chance-driven exercise. There is no science to it. Equity investing is also about the future. No fund manager knows how the future is going to pan out. Fund managers construct portfolios based on their investment style biases, guesswork, and judgment calls. Fund managers themselves cannot tell how their funds would fare over the next 10-15 years. They cannot even tell if they would continue to manage these funds for that long.

But investors and advisers want to believe they can predict the future performance of these funds and fund managers in advance today. This is humanly impossible.

Even if one picks a fund that would beat the index over the next 15-20 years, it will go through periods of underperformance. When a fund starts underperforming, we never know if it will recover, beat the index, or continue underperforming. The fund manager may be unable to protect his job before his fund recovers. Prashant Jain confessed in a conversation with Rajiv Thakkar in 2020 that he was on the verge of losing his job a few times. But luckily, his funds recovered just in time.

Many investors and advisers exit an underperforming fund and start investing in the best-performing fund of the recent past. This strategy looks sensible, but it guarantees underperformance. You enter a fund when it has already performed well; stay in it until it underperforms, exit it to invest in a better-performing fund, and repeat the process. You are taking underperformance from every fund that you are investing in. Frequent changes in the portfolio also incur a tax liability, which further reduces return and the probability of beating the index.

Investors and advisers who believe they can pick winning funds of the future in advance today should read about Warren Buffett’s bet with the hedge fund industry.

Three important lessons to learn from Warren Buffet’s $1 Million Bet

7. There is no downside protection in Index Funds.

 When used in the context that Index Funds fall as much as the market in market corrections, this is not a misconception. But to believe that fund managers provide downside protection is folly. Too many actively managed funds fall more than broad market indices in market corrections.

The equity part of the portfolio going down in a market correction is part of the game. But this risk can always be managed at the asset allocation level.

8. Midcap and Smallcap Funds beat the index.

When data show that more than 50% actively managed funds underperform the index in Midcap and Smallcap, it is wrong to say that actively managed funds beat the index in Midcap & Smallcap. SPIVA India Scorecard suggests that it is easier to beat the index in Midcap and Smallcap. But there are two problems in drawing this inference from the SPIVA India Scorecard.

SPIVA combines Midcap and Smallcap Funds in one category and compares their returns with S&P BSE 400 MidSmallCap Index. This is unlikely to provide the correct picture. Unless and until SPIVA compares Midcap Funds with the Midcap 150 Index and Smallcap Funds with Smallcap 250 Index, we would not know how fund managers are faring in Midcap and Smallcap against their respective indices.

Midcap and Smallcap Fund managers also have the liberty to invest up to 35% of the portfolio outside Midcap and Smallcap index constituents. So even if a Midcap or Smallcap fund beats the index, we cannot know if the fund manager has really beaten the index, or if it was because of his investments outside Midcap or Smallcap companies.

“If the data do not prove that indexing wins, well, the data are wrong.” – John C. Bogle

  9. Finally, the mother of all misconceptions is “Indexing works in the US but not in India.”

 This is akin to saying 2+2 is 4 in the US but not in India.

Please check my articles The arithmetic of indexing explained and The efficient market hypothesis and indexing in India over the next 20-30 years to fully appreciate this point.

The portfolios of market cap weighted index funds are such that the weightage of each stock in them is the same as their weightage in the collective portfolio of all active investors investing in that segment of the market. When the weightage is the same, the return also must be the same. Therefore, before cost, the return on the average actively managed rupee is always the same as the return on the average passively managed rupee.

But there are costs involved in investing, and active investing costs significantly more than indexing. Therefore, post cost, the return on the average actively managed rupee will always be less than the return on the average passively managed rupee. This is a mathematical fact. And mathematics doesn’t change whether you use it in the US or India.

“The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of professionals.” –Warren Buffett

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