Last Updated on December 29, 2021 at 6:10 pm
The interest in index investing is growing in India, but few understand what indexing is and why it works. In this article, SEBI registered fee-only advisor Swapnil Kendhe explains the basics of indexing and why it is effective.
About the author: Swapnil is a SEBI Registered Investment Advisor and part of my fee-only financial planners’ list. You can learn more about him and his service via his website, Vivektaru. In the recently conducted survey of readers working with fee-only advisers, Swapnil has received excellent feedback from clients: Are clients happy with fee-only financial advisors: Survey Results. 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:
- Want to build an equity mutual fund portfolio? Try these simple steps!
- Basics of Debt Mutual Funds Explained for New Investors
- Three Key Mutual Fund Terms All Retail Investors Should Know
- Debt Mutual Fund Categories Explained For Retail Investors
- Are you a conservative investor? Here is how you can grow your money smartly.
- SEBI Registered Investment Adviser Application Process: step by step guide
- Looking for a fee-only financial planner? Here is a list of questions to ask before you sign up
- Should Mutual Fund Distributors become SEBI Registered Investment Advisors?
- Everything you need to know about equity portfolio construction
- Should I pay a financial planner who only recommends index funds?
- Try these back-of-the-envelope financial planning calculations!
“Don’t look for the needle – buy the haystack.”
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
“In its purest form, an index fund buys all the securities in a market in proportions equal to their relative values. Equivalently, it holds x percentage of outstanding shares (or certificates) of every security in the market.” – William Sharpe.
If you wish to perfectly index the Indian stock market, you would have to buy a fixed percentage of every listed company’s outstanding stocks in India. If you hold 0.00001% of outstanding stocks of HDFC Bank, you must also hold 0.00001% of outstanding stocks of Reliance and that of every other listed company in India. You would then have a perfect Indian stock market index portfolio or the market portfolio. When an investor holds the same percentage of all available securities’ outstanding shares, he “holds a market portfolio”.
Since stocks owned by promoters and strategic investors are not readily available in the secondary market, all index funds and index ETFs are free-float market capitalisation based. They hold a fixed percentage of free float shares/free-float market capitalisation of all listed companies in a market or segment of a market.
Each stock’s weightage in an index fund is different because the free-float market capitalisation of each stock in the index is different. If the market value of the free-float of HDFC Bank is higher than that of IndusInd Bank, the weightage of HDFC Bank stock in the Index fund will be higher than that of IndusInd Bank, though the index fund is holding the same percentage of the free-float market capitalisation of both Banks.
Index funds like Nifty Index Fund, Nifty 100 Index Fund are attempting to index a portion of the market. These index funds don’t perfectly index the Indian stock market. A low-cost Nifty 500 Index Fund would be a better choice for an index investor since it captures a bigger portion of the listed Indian equity market.
If we get an ultra-low-cost Nifty 500 Index Fund and if all the active investors pick stocks from Nifty 500 companies, then before costs, the return on the average actively managed rupee will equal the return of the Nifty 500 index fund. Why?
For easier understanding, let us assume that ‘A’ and ‘B’ are the only two listed companies on a stock exchange. There are 150 stocks of ‘A’ and 100 stocks of ‘B’. The initial price of both ‘A’ and ‘B’ is 1000. After a few months, the price of ‘A’ increases to 1200 & the price of ‘B’ increases to 1300.
| Stock Name | A | B |
| No. of stocks | 150 | 100 |
| Initial Price | 1000 | 1000 |
| Final Price | 1200 | 1300 |
| Return | 20.00% | 30.00% |
Suppose there are only 3 investors in the market who are collectively holding both these stocks. One of these 3 investors is a passive investor who believes in indexing, while the other 2 are active investors. Let’s say their names are ‘Passive’, ‘Active1’ and ‘Active2’.
Since ‘Passive’ believes in indexing, he holds the same percentage of outstanding stocks/the same percentage of the market value of both ‘A’ and ‘B’. Suppose ‘Passive’ holds 10% of outstanding stocks of ‘A’ and ‘B,’ i.e. 15 stocks of ‘A’ (10% of 150) and 10 stocks of ‘B’ (10% of 100).
The balance stocks of ‘A’ and ‘B’ shall be held collectively by ‘Active1’ & ‘Active2’.
Notice that the collective return of ‘Active1’ and ‘Active2’ is the same as that of the return of ‘Passive’. This happened because, just like ‘Passive’ is holding the same percentage of outstanding stocks of ‘A’ and ‘B’ (10%), ‘Active1’ and ‘Active2’ are also collectively holding the same percentage of outstanding stocks of A and B (90%).
If you hold the same percentage of all listed companies’ outstanding stocks, the weightage of each stock in your portfolio is the same whether you hold 0.00001% of outstanding shares of all companies, 10% or 90%.
Since the collective return of ‘Active1’ and ‘Active2’ is the same as that of ‘Passive’, if one of the two active investors’ portfolio generates a higher return than ‘Passive’, the other active investor’s portfolio must underperform ‘Passive’.
Between stocks ‘A’ and ‘B’, stock ‘B’ has generated a higher return than stock ‘A’. If ‘Active 1’ is to outperform ‘Passive’, he must have a higher weightage of ‘B’ in his portfolio than the weightage of ‘B’ in Passive’s portfolio.
Suppose ‘Active1’ holds 70 stocks of ‘B’ and 75 stocks of ‘A’. The initial weightage of ‘B’ in Active1’s portfolio will be 48%. Remember, the weightage of ‘B’ in Passive’s portfolio is 40%. With this allocation, ‘Active1’ would outperform ‘Passive’.
But this would leave Active2’s portfolio with 60 stocks of ‘A’ (‘Passive’ & ‘Active1’ are holding 15+75, i.e. 90 stocks of ‘A’) & 20 stocks of ‘B’ (‘Passive’ and ‘Active1’ are holding 10+70, i.e. 80 stocks of ‘A’.) So Active2’s portfolio would have a lower weightage of ‘B’ than the weightage of ‘B’ in Passive’s portfolio. Therefore ‘Active2’ would underperform ‘Passive’.
No matter what ‘Active1’ and ‘Active2’ do individually if one of them holds a higher weightage of higher return generating stock in his portfolio than the weightage of that stock in Passive’s portfolio, the other must hold a lower weightage of that stock in his portfolio. Therefore, if one of two active investors is to outperform ‘Passive’, the other must underperform.
The same arithmetic is in play in listed equity markets. The index investor’s portfolio weights are exactly the same as active investors’ aggregate portfolio weights if active investors select stocks from the same universe from which we construct the index portfolio. Therefore, before costs, 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 management costs significantly more than passive management. Therefore, post cost, the return on the average actively managed rupee will always be less than the return on the average passively managed rupee.
At times, it is possible for actively managed large cap funds in aggregate to outperform Nifty 100 TRI or actively managed midcap funds in aggregate to outperform Nifty Midcap 150 TRI. There are two reasons for it.
1) There are other active investors in the market, along with mutual fund managers.
2) Nifty 100 TRI and Nifty Midcap 150 TRI are inexact benchmarks of actively managed largecap and midcap funds. Actively managed large cap funds can invest up to 20% of the portfolio outside Nifty 100 companies, while actively managed midcap funds can invest up to 35% outside Nifty Midcap 150 companies.
You can always find funds that have beaten the index in the past, but there is no certainty that these funds will continue to beat the index. We cannot predict the future performance of actively managed funds. There is human behaviour involved in fund management. Human behaviour is inconsistent and therefore unpredictable. There is no science in identifying winning funds of the future in advance. The whole exercise is chance driven.
Typically, investors invest in an actively managed fund that has beaten the index and its peers in the recent past. They keep the fund until it underperforms and then searches for another hot fund. This activity generates intellectual stimulation but results in underperformance over the long term.
It is a mathematical fact that indexing works. If you are a retail investor who lacks the knowledge and time required to do successful active investing, there is no better strategy than indexing. Active investors believe they can beat the market, but the cold fact is, most can’t, and most won’t. Index investors get a better return than most active investors.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)