Index funds were designed 45 years back by Jack Bogle for the average Joe investor. This product innovation was designed to be simple in construct, low on expenses and in a format that doesn’t require the investor to take decisions on which stocks to or which fund manager to trust. Over time, index funds caught the imagination of millions of consumers and in the August of 2019, the money invested in index funds exceeded that of actively managed mutual funds in the United States with over $4 trillion in assets under management. Make way for Index funds – the king of investing!
What are Index Funds?
As the name suggests, Index funds are funds that invest in an index. And an index is a combination of stocks chosen per a certain system with no active intervention. So when you invest in an index fund, you are buying a combination of stocks as per a certain defined criteria. The index can be broad-based or focused on a narrow segment of stocks.
Let’s understand this with an example. Vanguard is one of the most popular fund houses which offers the Vanguard Total Stock Market Index or VTSMX for short. The VTSMX is one of the world’s largest mutual funds with $897 billion in investments (as on 30-Nov-2019). It’s simplicity is what has led to the popularity of VTSMX as it provides investors with exposure to the entire equity market in the United States by including each and every investable stock in the United States whether it is a large cap, mid cap or small cap stocks.
Now, let’s understand the index construct. The model assigns a weightage to all stocks (about 4,000 stocks on last count) and your money will be invested in all 4,000 stocks in that assigned weightage. For example – the company with the highest market capitalization in the United States is Microsoft Corporation with $1.22 trillion in market capitalization. Now the entire US stock market is worth $33 trillion which means Microsoft Corporation’s valuation is about 3.70% of the US stock markets. Thus, when you invest $10,000 in the VTSMX index, $370 (3.7% of $10,000) shall be used to purchase Microsoft Corporation shares .. and so on and so forth.
The VTSMX has a mix of large, mid and small cap stocks and due the weighting criteria, we find that roughly 80% of the index is in large cap stocks, 12% in mid-cap and approximately 6% in small cap stocks. A key attribute of an index fund is costs and the VTSMX has a ridiculously low cost of 0.14% which is a steal when compared to most active mutual funds that charge almost 1% in fund management fees.
Beyond board diversification and a low expense ratio, VTSMX also offers tax efficiency. Tax efficiency has nothing to do with paying lower taxes but more about ensuring the fund doesn’t resort to practices that require paying capital gain taxes. The VTSMX Index Fund accomplishes this by keeping the turnover at just 3%. The other way tax is charged is on dividends but with a broad stock market dividend yield of 1.7%, taxes on that are not too significant either.
Why are Index Funds so popular?
Index funds in the United States have gained popularity over the last decade which saw a 300% growth in the amount invested in these passive investing instruments. From a base of $1 trillion in 2010, index funds crossed $4 trillion in mid-2019.
On the face of it, there is no reason for index funds to be as popular as it has become. Afterall, in a world where everyone tries to beat the market, index funds comes with an underlying principle that it is very difficult to beat the market and by construct, index funds never beat the market. So what do they beat – they beat up most actively-managed funds real bad in terms of offering relatively better returns. To put numbers behind that, in the last one decade, 85% of large-cap mutual funds ended up underperforming the S&P 500. And if this study was extended to 15 years, then nearly 92% of funds are trailing the index. Mid-cap and small-cap funds in the United States have faired even worse.
The second factor that has helped jumpstart the popularity of index funds has been the move towards lower fees. The 2008 financial crisis exposed the excesses of Wall Street fund managers which accelerated the move towards consumers moving their monies from active funds to passive funds.
Investors are realizing that the idea of “pay more to get more” isn’t necessarily true — and that the more you pay, the less you get in returnsBen Johnson, Global Director of ETF Research at Morningstar
The average equity Index fund in the United States have an expense ratio of 0.09% while the average actively-managed equity mutual fund has an expense ratio of 0.82%. That differential of 0.73%, when compounded over many years can come out to be a substantial gain for an investor. This is a concept that investors have started to align themselves to which has contributed to the popularity of index funds.
Let’s understand this with an example.
Say you invested $10,000 for 30 years and your annual return was 10%. If you had paid 0.09% in expenses yearly in an index fund, then you would have accumulated about $1,700,000 over three decades.
On the other hand, if you have invested in an actively-managed mutual fund with an expense ratio of 0.82% and assuming it delivered the same 10% pre-expense return, then your corpus would have grown to $1,400,000 in thirty years.
Net net, what happened to the balance $300,000? This is what you as an investor lost out and this is what the fund managers of the actively managed mutual fund carved out from your returns.
Costs really matter in investments. If returns are going to be 7 or 8% and you’re paying 1% for fees, that makes an enormous difference in how much money you’re going to have in retirementWarren Buffett on CNBC in 2017
Seven Benefits of Index Funds
Index funds offer seven benefits over actively-managed mutual funds
- Simplicity – Index funds are simple in construct and does not require an investor to worry about allocation amongst different market capitalizations or choosing a fund manager
- Diversification – Index funds are more diversified than most actively-managed mutual funds as the indices pack in many stocks that fit the index categorization criteria (e.g. 500 stocks in the S&P 500 or 50 stocks in the NSE Nifty). This diversification often helps lowering volatility and offers good risk-adjusted returns
- Low Costs – Index funds have much lower expenses than active funds. These funds save on fund managers, research analysts, don’t build distribution strongholds and their low turnover ensures lower transaction cost
- Transparency – As index funds track the index, investors can know on any day what stocks they will hold
- Long-term – Index funds are excellent instruments for long-term investing and often are the preferred assets to have to support one’s retirement and decade-long goals
- Eliminates fund manager risk – In an index fund, a fund manager’s individual style and investing strategy does not matter which means the risk of under-performance due the fund manager is completely eliminated
- Better performance – Index funds tend to perform better than actively-managed funds over the long run. Over the last 10 years – 85% of actively managed large-cap funds, 96% of actively-managed mid cap funds and 96% of actively-managed small cap funds – have underperformed their indices.
How Index funds started?
Jack Bogle founded the Vanguard Company in 1974 and presented to the world a new style of investing which has since become the default mode of investing for millions in developed markets like the United States. Until the launch of the Vanguard 500 index fund in 1976, brokerage houses and mutual funds acted as gatekeepers of the stock market and would let investors in only after ensuring they get a big slice in investment fees which were a full percentage point or more as compared to the much smaller fees we see now.
Jack Bogle drew inspiration from the “Efficient Markets” theory which says that the stock market prices fully reflect all available information at that time. This viewpoint is contrary to how proponents of value investing say but we’ll not delve much into that for now. The implication of the “efficient market” theory was that it is impossible to “beat the market” consistently on a risk-adjusted basis as market prices should only react to new information.
Using this simple insight, Bogle created a completely new philosophy of investing which was built on keeping costs at its lowest.
This cost management was done in multiple ways –
- Keep portfolio turnover low (3-5%) to reduce brokerage and taxes (comparably, active mutual funds have a portfolio turnover of over 30%)
- Minimal advertising costs
- Minimise distribution costs
These initiatives kept fees & expenses of running the fund at its lowest which all added up to the net returns to the investor.
As a result of Bogle’s vision, the expense ratio for Vanguard’s funds were just 20% of any actively managed mutual fund in the United States. This 50-60 bps differential almost automatically ensured that the Vanguard Index fund outperformed a majority of the actively managed funds on a consistent basis.
Vanguard reached $6 trillion in assets late last year with over 30 million investors in about 170 countries around the world.
Jack Bogle passed away on January 16, 2019 aged 89 but his legacy will remain for years as the man who did the most for the average investor. One of his books I recommend is Bogle On Mutual Funds: New Perspectives For The Intelligent Investor
Watch this video for a quick overview of Jack Bogle, the father of index funds
Index Funds in India
The amount invested in Index funds in November 2019 was only ₹7,700 crores which says there is a long way for it to go in India in terms of its benefits and awareness.
The NSE and the BSE have certainly done their part by creating an array of indices in the equity and the fixed income side. For a detailed understanding of these indices, refer to my post “A Complete Investor Guide to Nifty50, Bank Nifty & 65 Other Indices” for information on how these indices are created, its constituents and composition.
Index funds are not on the distributor’s plate
Mutual funds in India have largely been an intermediary driven business where push selling and distribution fees plays a big part in deciding what gets sold. On the other hand, mature markets are seeing commissions closer to zero with advisors charging the customer for advice. With little commission on index funds (as expense ratios are minimal), there is a lack of incentive amongst the distributor community to promote these instruments. The good news is that India has recently seen the emergence of direct plans which are being promoted through platforms like ETMONEY, PayTM MONEY, Groww, Kuvera etc. that are better placed at increasing the awareness of index funds.
Indians look for returns and not risk-adjusted returns
The concept of looking at returns and risk simultaneously has not caught the average Indian investor’s mind. Actively managed funds often have string periods of over-achievement and uner-achievement as compared to their benchmark indices. However, consumers tend to ignore these in their calculations as they chase only the returns column of mutual fund tracking websites and apps. Do read my post on “How to Measure Risk” to get more insights on factoring risk into your stock or mutual fund buying decision.
Since the average Indian chases returns he tends to often buy an actively-managed mutual fund that’s doing better than benchmark, hold on to it until the fund performance goes south, redeems it and replaces it with another fund. In other words, the average Indian is worse off than before because he has not made much on the mutual fund he originally bought because of the ups and downs and ended up paying more from his pocket due to taxes on capital gains.
Performance of Index funds as compared to Actively managed funds in India
The SPIVA India Scorecard is a research document released by S&P Global which shows some interesting insights on actively managed and passively managed index funds. The document compares the performance of actively managed Indian mutual funds with their respective benchmark indices over a 1 year, 3 year, 5 year and 10 year period. You can view the entire report here.
The study found that the under-performance to benchmark for actively-managed funds is quite high in large-cap funds as compared to mid & small-cap funds. Please refer to the table below –
The data shows that most actively-managed funds have not been able to outperform the index across different time frames. The corporate bond funds have been the worst performers here followed by government bonds and large-cap mutual funds. As an investor, I am quite in a quandary because the appreciation of my wealth is as much a factor on my decision of which fund (and fund manager) to go with and I have a chance of being wrong 9 out of 10 times. This makes all the more reason to opt for passively managed index funds.
Now, let’s also examine how the average mutual fund has performed against it’s benchmark –
Here too we see that on most discrete periods, the benchmark performed better than the average mutual fund in the large, mid/small, ELSS, government bond and corporate bond space.
Further studies elsewhere have raised expectations that this underformance from actively managed funds is bound to continue over time and mutual funds esp. large cap MFs will find it difficult to justify their fees.
Infact, this trend of equity fund under-performance is not specific to India and even the SPIVA report for the United States shows that 78% of large cap funds in the US have underperformed their index over a 5-year period with even greater variances in the 1 and 3 year period. In Europe, 90% of equity funds underperformed their benchmark over an year and 77% over five years.
There does exist a strong case for a monumental shift from active investing to passive investing in India and I expect index funds to make headway over the next decade and garner a larger portion of the mutual fund space as the Indian market matures