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It's not yet time for index funds

It's useful to periodically enquire whether it's time to switch to index funds because the answer is a moving target

It's not yet time for index funds

A certain kind of sophisticated investor, especially one who reads about investing as it has evolved in the US and Europe, frequently asks about index investing. Has the time for index investing come yet? The 'yet' is very important. The reason is that if you expect the experience of the developed markets to get replicated in India, then a wholesale switch to index investing looks inevitable.

Is that assumption correct? Our analysis demonstrates that it's not time yet, nor will it likely be over the short term. However, beyond that, in all honesty, I must confess that I don't know. Like a school or college debater, I can argue either for or against the motion and I'm confident that I can make a good case either way. However, I genuinely feel that like so much else in the markets, we'll know this only when it happens.

It's possible to convince oneself that the reasons for not going with index funds will continue to hold true years into the future, and that's certainly possible. Conversely, you could look into the past and draw a trendline which will lead you to a different conclusion. There was a time when almost all equity funds (I'm talking of 90 per cent kind of numbers here) would continuously beat the indices year after year. In those days, it was a no-brainer to invest in actively managed funds on performance alone. Nowadays, the situation is more complicated and compared to the past, index funds are closer to making sense.

It's a question that I end up revisiting once every year, mostly because a certain number of people keep asking it. Is it time for Indian investors to take index investing seriously? In other words, should passive investing be the logical choice for an increasing number of investors? It's useful to ask this question periodically because the answer is a moving target. The correct answer (and the reasons for it) are different today than it was five years ago and it will be different five years in the future.

Let us, for a moment, revisit the definition and logic of index funds. Normal mutual funds aim to beat the markets, i.e., they aim to have better returns than a market index. Some of them succeed; many do not. In contrast, index funds aim to just replicate the performance of an index, neither better nor worse. Thus, an index fund that is based on the BSE Sensex should have exactly the same 30 stocks that the Sensex has in exactly the same proportion. Investors who put their money in such a fund would get returns that are identical to those of the BSE Sensex.

In a way, index funds reverse the logic of mutual funds. Fund managers are supposed to work actively to give individual investors the professional investment management that investors don't have the expertise for. Instead, index funds are based on the idea that fund managers themselves don't have their expertise or that it's not worthwhile to try and spot them. A powerful driver of index-fund performance has been low cost, which translates into better returns for investors.

Historically, in the western markets, index funds have succeeded because despite their high cost, active fund managers are unable to beat the indices. A second factor, not so frequently mentioned, is that an index fund absolves advisors of any blame. If it does badly, then it's not the advisors' fault but the fault of the index, meaning it's no one's fault. Another factor again not frequently mentioned was the historical role played by one man and the company he founded - John Bogle and Vanguard. It is conceivable that without Bogle, passive investment would never have taken off.

Do we have someone able and willing to be India's John Bogle? Looking around our financial sector; it doesn't look like that.