We all know that it's unwise to put all your eggs in one basket. But is it also foolish to have too many eggs? Is too much of diversification a bad thing? These are the questions that come to mind when talking about the Benchmark S&P CNX 500 Fund. This index fund will follow the investment pattern of the stated index, which means an investment in 500 stocks. That is an awful lot of stocks to have in your portfolio. The fund uses various angles to sell the idea. All of them legitimate but not necessary great reasons to dump actively managed funds.
Is the Benchmark logic justified?
The Asset Management Company (AMC) says that it's difficult for an investor to decide on a scheme since there are so many. True. But if the investor goes for a diversified equity scheme that has proved its worth over various bull and bear periods, the list would narrow down considerably. And if the fund manager quits or the fund gets downgraded, the investor can stop further investment in the fund or even sell his holdings. No one is married to their investment.
It's a valid point that an investor cannot pick up a fund based on a theme. After all, themes keep changing with the times. Investors must keep a few diversified equity funds as core holdings. These must be funds that have had a good track record over a number of years. Once a solid core is in place, you can add thematic funds to provide for that extra diversification or add alpha to your investment portfolio.
It is all very well to say that this fund will cover virtually every theme and sector in the market. According to data provided by Benchmark Mutual Fund, the S&P CNX 500 index covers 92.61 per cent of the total market cap of all the stocks listed on the Bombay Stock Exchange and National Stock Exchange, much higher than that of the Nifty (63.32%) or Sensex (48.14%). But should the market be riding on a theme or sector, this fund will not be able to deliver exceptionally as it won't have the leeway that other active fund managers do. For instance, in 2007, the BSE Metal and BSE Power indices returned 121.47 per cent and 122.07 per cent as against 62.51 per cent of the S&P CNX 500. Fund managers who rode the energy theme delivered astoundingly.
This fund will encapsulate all sectors and themes and market caps due its very broad base. That by itself should give a conservative investor a good sound sleep. But it will diminish returns. That's simply because if you have too many investments, the positive contribution of one won't be big enough to make a difference. For example, if a sector comprises just 5 per cent of your portfolio, even if it rallies greatly, it will not make a significant difference to the entire portfolio. Neither does the fund manager have the discretion to play around with it to increase return. Ditto with stocks. If a multibagger corners just 2 per cent of the portfolio, it won't make a material difference in the overall portfolio. So the argument that it is less likely to miss out on an emerging star is debateable.
Is the market more efficient?
Index funds are a great option in an efficient market. The efficient market theory holds that stock prices generally reflect all that's known about a company. In such a market, it's impossible for investors to gain above average returns because all relevant information that may affect a stock's price is already incorporated within its price. That makes it difficult for an investor to unearth information not already reflected in the company's stock price. Thus the scope for hunting “undiscovered gems” is diminished. So if all fund managers are investing in the same pool of stocks, it stands to reason that the average fund will do no better than the market's average performance.
Nothing proves a point more than hard numbers. If markets are indeed getting more efficient, one should not see active funds beat passive funds by huge margin. Even if we take into account risk adjusted and expense adjusted returns, it has been the case of actively managed funds outperforming the passive ones. If one looks at the best performers in 2006 (UTI Infrastructure - 61.48%), 2007 (JM Basic -111.44%) and 2008 (DSPBR Equity Inst - -23.28%), there is evidence that active funds can outdo the index by a wide margin.
But that does not mean that no portfolio should incorporate an index fund. If you want an equity exposure but are not inclined to take a lot of risk, then an index fund is the best bet. You can make it your core holding and add other diversified equity funds to your portfolio if you wish to.
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