Can ETF find a place in your portfolio?

Star investor Warren Buffett in 2007 placed a $ 1 Million bet where the selected indexed funds over a basket of select fund managers. The terms of the bet were that the performance of an S&P 500 index fund will be compared with the performance of a basket of fund managers over the course of 10 years. And guess what, Warren Buffet won the bet in 2017 as the S&P 500 fund returned a compounded annual return of 7.1% as compared to 2.2% by the basket of fund managers over the course of 10 years.

Now, let’s understand. What is an index fund?

An index fund is a type of MF scheme which invests in a pre-defined set of stocks of an index. This fund allocates money in exactly the same proportion as per the weight of an index. In other words, an index fund is a passively managed fund where the fund manager just buys and holds stocks that form a part of an index and exactly in the same proportion.

it is absolutely obvious to say that index funds track the performance of the index and as a result will give the same return as the index. Some funds are also designed to track tailored indexes that track specific sectors or geography. So when that particular sector or geography performs well, the index will perform well which in turn makes the performance of the fund better.

Here are some of the reasons one should invest in index funds.

  1. Lower expense ratio

One key advantage of investing in an index fund VS a regular mutual fund is that the index funds operate at a very low expense ratio compared to an ordinary mutual fund. To see this practically, we have compared UTI Nifty Index Fund with HDFC Top 100 fund which is a large-cap focused fund managed by one of the most respected fund managers in the business.

Regular Plan HDFC Fund

As you can see here, there is a drastic difference in their expense ratios. The expense ratio of the index fund is 0.17% while the expense ratio of HDFC top 100 is much much higher at 2.08%. Another point to notice is that the index fund doesn’t have an exit load, unlike an ordinary fund.

  1. Long term outperformance –better returns on a risk-adjusted basis than the category as a whole

Performance 1Performance 2

When we compare the turnover of an index fund with that of an ordinary mutual fund, most of the funds will have a much higher turnover than an index fund. Also, when we compare return and risk measures we can see that the index fund performs better than the rest.

Reasons for not investing in index funds:

  1. Index funds buy high and sell low – Our index tracks the market cap. Therefore, as the company increases in market cap i.e. it gets more costly in price, the more it is supposed to be bought by the manager managing the ETF
  1. Index funds buy past winners–Index funds have most of their money in mature companies which are winners of the past. So the index fund is a group of mature companies which are more likely to face stagnation or decline going forward (Except a few companies led by very efficient management)

Chart

Britannia Industries as we all know is a very well-known company operating in a mature industry with very good penetration. Britannia got a place in the index from 29th March 2018. It was at a market cap of Rs.74,000 Cr. approx. the company has multiplied investors’ wealth by 18.5 times in 9 years which is a CAGR of 39%. Now, will the company be able to show such strong growth in the next 9 years to come?

  1. Index funds can’t get rid of bad companies unlike active managers– As the index track’s the market cap, it drops companies that are not doing well in the stock market and adds others who are doing well. The index fund manager has to stick with these companies until the index drops them while an active manager can get rid of the same anytime.

Here are some examples of companies which an active manager would have sold way before they were shown the exit door from the index.

Jaypee

reliance power

Here are two companies “Jaypee Associates” and “Reliance Power” which were shown the way out of the index at the respective dates on 28th March 2014 and 28th April 2018. Another observation we can make is that price on for both the companies was at its bottom when they were removed from the index.

Therefore, it is clear that an index fund manager has to stick with a bad company until it is removed from the index. So, in this case, the index fund manager must have held on to both the companies till their exit date from the index and on the other hand, an active manager would have exited them much before.

  1. Lack of flexibility to take advantage of manager’s input –as it is clear now that an index fund follows an index point to point, there is no flexibility for an index fund manager to deviate from the index even though he has a good analysis backing to deviate from the index weights.

Therefore, an index fund manager becomes somebody who just has to make sure that the fund tracks the index thoroughly and not give his personal input at all.

Why does Buffett & Graham recommend index funds to an average person?

They recommend index funds because it makes sense to invest in the index in the USA as their index includes 500 companies compared to our NIFTY 50 which only includes 50 companies.

Another reason is that if there is a great company which is mostly held by promoters will never find a place in SENSEX. It is a simple collection of most expensive stocks. Because any company which has seen a sharp rise in price will find itself in the index but that is not the way you buy stocks, right?

One more reason why it makes sense to invest in ETF in the US is that the US is a highly developed market with negligible hidden opportunities therefore, it becomes very difficult to beat the index with active management. India however, is an emerging market with many hidden opportunities so it is relatively easy to beat the index.

Eventually, an investor’s choice between an ETF and Stock boils down to his/her expertise and capacity to give time in analyzing and tracking his investments. If an investor believes that he has the required knowledge and expertise and also the time to manage his investments he can go and buy individual stocks.

At this point, one question should pop up in your mind. Is it not possible for an individual investor who doesn’t have the time and ability to pick stocks to beat the index?

table

The good news is the answer to the above question YES it is possible to beat the index. An investor who wants to beat the index without active participation can do so with the help of a good mutual fund or a PMS (Minimum investment can be a hurdle here). Here is a comparison of ETF vis-à-vis a good mutual fund.

The above comparison makes it evident that a good mutual fund manager can help an individual investor beat the ETF. To sum this up, if an individual has a good financial advisor who can help him pick up good funds can make an investor achieve his goal of outperforming the index.

So if an investor is not confident about his ability and capacity to give time, he should go for an index ETF or a mutual fund as they are managed by experts whose sole job is to manage funds.

  • -Navid Virani
  • Research Analyst

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