The case for index funds is worth making again. The simplicity of concept, low cost and ease of implementation make it the default product choice. While investing in equity, there are three choices— invest directly in shares, choose a manager to build a portfolio, either a mutual fund or a PMS, or buy the index. An investor needs all three.
Many argue that careful construction of a portfolio will beat the index. The truth is actual performance lies above and below the index, when measured for specific periods. Every year, there will be outperformers and underperformers. Investorsflock to the performing fund “after” it has beaten the index. Fund selection is not an exact science, and there will be hits and misses. There is no way to tell in advance which fund will beat index.
There are two components to the returns one makes from equity investing. The first is basic market returns represented by the index, which is the beta return or return made by being in equity overall. The second is the incremental return, over and above the index, which we call alpha. This return is attributable to efforts by the fund or investment manager, or adviser who selects funds. Have funds delivered alpha? Yes. Have advisers delivered alpha? Yes. Have most investors chosen such funds and advisers? No. This is because investors can’t make such choices without errors. There will always be a set of funds beating the index, but without luck, the investors cannot sidestep the laggards and choose the leaders alone. Investors buy a set of stocks and funds and hope for the best. They mostly end up with average, which is the index.
Then, why do active fund management, active stock selection and active advisory thrive? For one John Bogle who was steadfast about the benefit of indexing, we have a Warren Buffet whose active returns are legendary. Whose path to follow? One is so easy to follow, you figure how to win. Another is so tough that you cannot win even if you try. There is a third one, where you may win or lose, and won’t know as you play along. But sometimes you win big. Equity investing is like that third game. So, investors, managers and advisers are able to keep their portfolios tuned for that big win, creating a buffer for a few losses that also come along. What if there is a skew in the index? Active funds with large-cap focus tend to do these modifications.
What can we do faced with these choices? A core and satellite portfolio is a helpful way to build a long-term portfolio. The core equity portfolio should be in low cost, passive index funds. You go where the market takes you. This strategy is easily implemented by buying ETFs. You don’t need to do any monitoring. Actively managed funds, PMS, and other products are the satellite portion of your portfolio. You hope to make an alpha, and you monitor what is going on. Stocks, sector funds, specialty products, are all tactical calls. They lie outside the core and satellite portfolios. They feed your fancy for windfalls. You invest a small portion, monitor closely, and book out when your bet isn’t working.
This edifice of your investments is built on the core, the passive index fund. Why is it not sold aggressively? The cost is so low that there is no money to pay commissions. Sometimes low risk strategies suffer from lack of advocacy. Such is the lure of return.