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Say hello to index investing?

Has the long-awaited moment of index investing finally arrived for Indian equity investors?

Say hello to index investing?

The age of index investing is coming. It's been on its way for a long time but finally, it's now closer than ever. Some people feel it's already here and for some, it surely is. Should you give up on trying to choose actively managed funds and just switch to index funds? Is it time yet? The answer, like so many other things in personal investing, is a 'definite maybe'!

So, should passive investing be the logical choice for a large number of investors? Unlike many other things in investing, it's a question that should be asked afresh periodically because the answer is a moving target. The correct answer - and the logic for that answer - is different today than it was five years ago and without a doubt, it will be different five years from now.

For those readers who are not familiar with the concept, I'll quickly recap the definition. Normal (actively managed) mutual funds aim to beat the markets, which is a way of saying that their aim is to give higher returns than a those from a market index. In contrast, index funds - also called passively managed 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 companies' 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 from the BSE Sensex.

In actively managed funds, fund managers are supposed to work actively to give individual investors the professional investment management that the 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 those few who do. Because index funds do not require fund management and research, they have much lower costs, and this itself improves performance.

Till about four-five years ago, it was a no-brainer for an Indian investor to try and choose actively managed funds which would outperform the indices. It wasn't difficult even though over the years, it had become increasingly less easy. Let's take the beginning and the end of what I would call the modern era of Indian equity investing, which, to my mind, began in 2003. In the five years from 2002 to 2006, 81 per cent of large-cap Indian equity funds beat the Sensex. In the five years ending just about now, 9 per cent of large-cap funds beat the Sensex. Because much has changed in the way funds are classified, the two are not exact equivalents but the difference is so gaping that no one can spin it as anything but a complete disaster. There are other types of funds, like multi-caps, that have done better and have been run as 'mostly large-cap' but while they are better than large-caps they are, on an average, well behind the big indices. The fact remains that during the 2002-2006 period you could have picked a fund randomly and you had an 81 per cent chance of beating the index. Those days are not coming back.

It's easy to see this as a large-cap problem but it's not. It's even harder to pick winners amongst funds that focus on companies lower down the size scale. Those that do well suffer from a peculiar winner's curse - they grow large but the thinness of mid- and small-cap markets in India means that large size itself portends failure. It's a downward slope from which few escape.

The problem is that this size curse is just as applicable to mid- and small-cap indices. At the end of the day, if we take the collapse of large-cap actively managed funds as a one-way street, then there is little to do except take Nifty and Sensex performance as the maximum that one can aspire to. To all of us who have seen the golden period of Indian equity investing, that sounds like a terrible fate.

Is there no way out? At the end of a depressing year, I don't want to end this column on a pessimistic note. So, in the future, I'll lay out a new path that mutual fund investors can follow in the times to come. Don't worry, all is not lost!