Index Investing: Pros and Cons

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Pros and Cons of Index Investing –  By Late Mr. Parag Parikh

Shuchi.P.Nahar

Index funds
are simply mutual funds that attempt to mimic a given market. There are actually many
more than that tracking many different markets of all shapes and sizes, but
each one shares the same basic principle: Its goal is simply to match that
particular market’s return.

Index
investing is therefore simply the process of using index funds to build a
passive investment strategy. Index investors decide which markets they want to
invest in, how much of their money to put in each one, and utilize index funds
to put that plan in place.

What is market?
Where do you see the market going? how is market judged? By what the index is judged?

These
are some of the basic questions that every investor asks sooner or later in his
investment journey
.

 If the index is up that means that the market
is up, sometimes you may find the market is going up but your portfolio has
not increased or decreased.

This was very
evident during the tech boom in 1999-2000 where the technology stocks formed
about 24% of the total index.

If you did not
possess technology stocks and if the index was going up everyone was
rejoicing around you they will think you are not never better off.

in fact every
multinational fast moving consumer good company with strong brands, if you had
them if you had good engineering companies like L & T anything
and you had a convention very good portfolio but during those times you were
always sad because while when the market is growing up but your stocks are
still the same but if you open the papers every day and they would say well the
index is up so much the markets are up so everyone is rejoicing but only a few
people were rejoicing now we have always talked about certain behavioral tendencies in the market.

 One of them is fancies of the market over a
period of time what happens is different stocks , different sectors they become
fancies in the market and when they become fancies in the market people only
follow them because our system is all designed in such a way that you only look
at that sector which is a fancy.

However,
whenever you are talking about a fancy of a sector what is a fancy everyone likes,
it is something everyone chases it. If the stock price starts going up so it
becomes a fancy why does everyone talk about it because the newspapers only
report whereas there has been an abnormal profit or a loss in the company.

 So during times of fancies in a sector like we
had in the technology boom 2006- 2007 we had the infrastructure boom, the
real-estate boom then we had the power boom, now that time all those sectors
were fancy and during that time if you bought any power stocks till date you would
be losing.

Similarly is
the case with technology stocks also that if you bought in forces in 1999- 2000
anything you are still not very well-off in fact you could be also losing so
sometimes when you are chasing a fancy you end up paying a fancy price and when
that fancy ends what happens is the losses start coming in your pockets.

So markets are
normally made up of a musical chair game and one point of time there is
something which is going up then second time something else comes up and the
real stocks , the real performers which have got steady income, steady
profits they never become fancy in the market they always perform properly.

Now what
are the stock markets anomaly?

Every company
would have its Growth phase, the maturity phase and eventually it will die, the
markets are made in such a way that what has to be discarded gets discarded and
the new things come because that is rule of the markets.

Everything is
based upon about continuity, however the companies which are listed in the
markets are about discontinuity because they go through their different
business cycles and that’s what happens in a market.

When you have
an index companies which are in the limelight, companies which are doing well
ultimately come and replace the companies which have become Laggard’ so index
was made with an idea to capture what the market is and how could they capture
what the market is only by looking at the size of the markets.

Now what does creative
disruption means
– to facilitate continuity by aiding with discontinuity of
the individual corporations so in that consists of a basket of the largest stocks
based on market capitalization.

Now this index
is based of the large market cap it is supposed to be representative of the
markets however what is in reality happening is when you are about 7,000 stocks
listed on the Bombay Stock Exchange the high market cap stocks which capture
the index the only 30 of them similarly is the case with NSE where the sample
size is only 50 stocks where they are more than about 3,000 stocks listed.

Now we are
going to look at the markets taking into consideration only the market cap if is
it the right way, are we really looking at the markets as it is said to be creative
disruption is in individual stocks ultimately they are thrown out of the
markets creative and new stocks new ideas, new sectors they start coming into
the markets.

 Let’s take an example there was a time
where we had the textile industry, today you’re doing exceedingly well in the
70s textile today define any textile representative but this is what creative disruption  is that at that point of time there was no
technology stocks so the markets as times change as things are changing you
have new sectors coming, some sectors moving out and vice e versa  so that’s what this called creative disruption

How does
one stock get into the index first case what is the listing history how long it
has been listed in the market?



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Secondly is
trading history today that how long people have been trading in that stock? How
much is the volumes in that stock?

Fiscal results
also do the same do play their part but there are times like you had with the case
of Reliance power that it was a big market capitalization although it was not a
profit-making company it got into the index in the same NSE the Nifty Index also
we had two companies one was Reliance Petroleum which was not a profit-making
and another was keinz. I think both of them because they were big that is why
they got into the markets that’s why for some of these management’s it is
important that they come out with big and big issues because we’ll see what
happens once the stocks get into the indices so now if you had all these things.

An effective
measure for us to judge the market by asking index key data index project up or
down I think just because there is some falsehood which is flowing and when everyone
is talking about that falsehood then I think it becomes a truth and that’s why
each one of us as the same question newspapers also report the same question
but if you really try to understand the basics of in the index then we come
to a realization well going there is no need to ask where the market is going
because if you are running certain stocks your job is to see whether your stocks
are doing well or not, not what the market is going because there may not be
any relation with that.

Value
investing is all about buy something which is reasonable, which is valuable
and
those are low P/E Stocks.

So, if it’s an
active investing in this form then how can a passive investing be really good?

Now let’s look
at some of the behavioral anomalies of the participants of the markets because
for some things which happen in the market is because of a whole lot of anomaly
is not only of the investors but it is also of the companies of the regulators
of the operators of the management let’s see them one by one.

1)The
mystery of the Unknown

So most of us
are always willing to pay something higher for something which is unknown for a
mystery and when the mystery get some reveal the charm of the newness goes away
and then the reality comes in this was very evident how did the tech boom start
where it was coming from everyone  that the
computers will lead to change and you will have to do certain things about the
world will come to an end.

What will happen
when everything was on computers and that’s how the tech boom started because nobody understood
what it is, so then you have so many companies coming in the technology boom
started and then ultimately with the internet and the dot-com boom in it. 

So everything goes in mystery for people that’s why we paid exorbitant prices even
a company small company like AOL they say it took over Time Warner Brothers so
all craziest things started using because the value of the unknown is a mystery.
So unknown that everyone was excited by it so there is one thing certain that
would happen it’s like in the markets Buy when everyone is panicky and sell
when everyone is interested.

2)
Management Greed

The management
of a company would always like the company to come into an index and management
really understands that it is the market cap that gets you in. Then they have
operators in the market, who can really run the stock prices.

I think those
companies whose market cap becomes big and that market caps ultimately helps
them to come so whoever wins out of management also they playing a very big
role in getting the stocks into the index because once your stock is in the index
there are many benefits not only it becomes a fancy for everyone,  not only most of the mutual funds and all they
invest into it but the management gains a lot of credibility the stock is an
index talk secondly, bankers and all they think they also lent against those
stocks so there were lot of other benefits which come in which increases the
management greed also if the market cap increases their own wealth also
increases so it becomes very easier for them to this thing you have this give
stock options and all those things so then they can attract better talent there
are a lot of other issues also.

3)
Operators

How do they go
to derivative operators because operators would love to rig up a stock
especially if it is going to get into the index it becomes easier so you have a
new breed of operators who are looking at rigging that this high market cap stocks?

4) Herd
Mentality

Herd mentality
we’ve always been talking about it that as more and more people try to get
into index talks when everyone is going, though it starts going with them so
it’s like a Pied Piper whatever he starts doing and then people start following.

When everyone starts
chasing and then you have a herd to follow that stock then that person again
becomes a salesman for that stock of course the operators and the herd mentality
they are one thing which go hand in hand together.

Quest: Why do
investors go for index investing?

Index investing
is just a heuristic in the mind it’s a mental shortcut the brain takes in
processing information.

 It is more processing all the information that’s
where you are taking shortcuts and that shortcuts are known as heuristics.

The herd
mentality it’s again everyone is buying so we want to go with it so you have a
big following coming in the mutual funds also if it is in the portfolio of 10
big mutual funds the small ones also would start going behind that.

Then comes no management
fees it is again a big trigger every day saying “I am saving that means my
returns will increase”. Secondly there is no regret aversion, if you have
bought an index stocks, if it goes down you would say the luxury of thinking
that its fine if index has gone down everyone else is also losing, if it went
up everyone else is winning. So here comes the comfort of not losing alone.

Employee
working won’t have to be worried about what the boss will say because he has
bought an index stock. They have all gone down so everyone was doing index
investing and now everyone is at the par level with you there cannot be any relative better performance
of bad performance. 

Secondly, they’re advertised very heavily and it creates an
availability bias for them because everyone is having deep pockets will always advertise
their funds talking about no management fees and that is what is liked by
people.

Index
Investing Is Low-Cost

One of the
biggest reasons that index investing is so effective is also one of the
simplest: It’s low-cost. Cost is actually the single best predictor of a mutual
fund’s future performance. Better than past returns. Better than the fund
manager’s track record. Low costs lead to better returns.

Index funds
are often the lowest-cost investments available simply because they don’t
require a portfolio manager who needs to be paid. And they also don’t incur all
the trading costs, taxes, and other expenses that go into some of the more
active strategies.

Index funds
have a simple job: track the market. That simplicity keeps costs low, and those
low costs are passed on to you in the form of higher returns.

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There
have been studies both in favor and against active management. Many managers
perform worse than their comparative benchmarks, but that does not change the
fact that there are exceptional managers who regularly outperform the market.
Index investing has merit if you want to take a broad economic view, but there
are many reasons why it’s not always the best route to achieving your personal
investing goals.

                             SHUCHI.P.NAHAR

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Shuchi Nahar
Shuchi is NISM Certified Equity Research Analyst, CFA - Level 1, a student of Law and Finance, and an aspiring CS.
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