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Why do stock indexes fail investors?

When actively managed equity funds continue to beat the indexes handily, can they be accepted as suitable benchmarks for them?

Why do stock indexes fail investors?

In Indian stock investing, it has long been known to anyone who looks at actual data (rather than theory) that equity mutual funds handily beat bellwether indices like Nifty and Sensex. For a certain type of opinionista, this is an uncomfortable fact. If you google "index investing" or "passive investing", then the received wisdom is that a vast majority of actively-managed equity funds cannot beat index-based (passive) investing. You may even come across a Dilbert comic strip where Dogbert says, "Studies have shown that monkeys can pick stocks better than most professionals. That's why the Dogbert Mutual Fund employs only monkeys."

That passive investing generally beats active investing is true in America and other equity markets in the developed countries. However, it's very far from the truth in India. And yet, one often hears and reads it being quoted as if it was a physical law of the universe that is equally true everywhere. This belief is given strength by the weight of authority that someone like Warren Buffett adds to it. In many of his interviews and annual shareholder letters, Buffett has unequivocally said so. In fact, it was the very point of his famous ten-year bet that a set of selected hedge funds could not outperform the S&P 500 over a decade.

However, so far, against all expectations, India is different. One doesn't have to prove this with selected funds, it's true of almost all funds. I tested this for a hypothetical situation, looking forward five years from April 1, 2013 to March 31, 2018. Over these five years, 297 of the 345 equity funds (86%) have beaten the Sensex and the Nifty. So it's clear that even in a monkey-chosen (randomly selected) equity mutual fund, it is overwhelmingly likely that you will get higher returns than the Sensex and the Nifty. Actually, it gets even better when one considers the actual money invested. Out of the Rs 1.78 lakh crore invested in these funds at that point of time, fully 97% (1.73 lakh crore) outperformed the Sensex and the Nifty over the following five years. That's the reality of passive investing in India. Anyone arguing otherwise is just copying and pasting imported opinions without respecting Indian data. These are the actual returns delivered to investors, after all costs have been charged by the fund.

Even if one uses the 'Total Returns' version (dividends included) of the Nifty, this 97% falls only to 90%. By the way, an important side-note on this issue--the total returns version of the BSE Sensex is a secret from you, the investing public. This is the case despite SEBI recently mandating that mutual funds that use the Sensex as a benchmark use the 'total returns' version of the index. So we now have a ridiculous situation where crucial information like the statutory benchmark index for investments offered to the public are not available to the public. This lack of transparency is a regulatory failure on SEBI's part.

The question arises as to why Indian equity funds beat the benchmarks so easily. A lot of investors and analysts have often speculated on the reasons and have come up with a variety of reasons for why Indian fund managers find it so trivially easy to beat these indices. However, as a start, one must recognise that if A outperforms B, then it could be that A is brilliant or that B is a dud or perhaps a combination of both. That means the question to ask is whether almost all Indian fund managers are brilliant with such consistency, or whether these indices are a dud for the purpose of being used as investment portfolios. While there are indeed some brilliant fund managers in India, I think it's much likelier that these indices are not a good proxy for 'buying India', having been designed for an entirely different purpose.

Of course, ever since the passive investing idea took hold, stock exchanges around the world have gotten into the business of mass-manufacturing of indexes and this is true in India as well. Unfortunately, many of these indices are essentially investment algorithms (or selections) that have been legitimised as a passive investing vehicle by an exchange launching an index based on it.

As is routine with the global financial services industry, they've taken a great idea--passive investing--and have distorted and debased it in as many ways as possible. As for the simple need of having indices that can serve as good benchmarks for funds, as well as suitable vehicles for passive investing, that's not being met in India.