Index funds were designed 45 years back by Jack Bogle for the average Joe investor. And it has turned out to one of the best product innovations in the investing space. The index fund is simple in construct, low on expenses and low on investor decisioning. No wonder, index funds are the preferred route for many consumers to create wealth.
In addition to being simple to understand & low on expenses, the index fund doesn’t require investors to take difficult decisions on which stocks to or which fund manager to trust.
Over time, index funds has caught the imagination of millions of consumers. In August 2019, the money invested in index funds exceeded that of actively managed mutual funds in the United States. Today, index funds have over $4 trillion in assets under management – and growing!
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. An index is a combination of stocks selected per a certain system with no active intervention. 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 can focus on a narrow segment of stocks.
Let’s understand this with an example.
Vanguard Total Stock Market Index (VTSMX)
Vanguard is one of the most popular fund houses. One of their popular funds is 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. The VTSMX provides investors with exposure to the entire equity market in the United States. This means the index includes each and every investable stock in the United States. This is irrespective of whether it is a large cap, mid cap or small cap stocks.
Now, let’s understand the index construct.
The model starts by assigning a weightage to all stocks (about 4,000 stocks on last count). Then, your money is invested in all 4,000 stocks in the assigned weightage.
For example – the company with the highest market capitalization in the United States is Microsoft Corporation. MSFT has a $1.22 trillion in market capitalization at the time of writing this article. The entire US stock market is worth $33 trillion. This makes Microsoft Corporation’s market valuation about 3.70% of the US stock markets. Thus, when you invest $10,000 in the VTSMX index, $370 (3.7% of $10,000) is used to purchase Microsoft Corporation shares. The same principle applies to the other 3,999 stocks.
The VTSMX has a mix of large, mid and small cap stocks. However, due the weighting criteria, we find that roughly 80% of the index is in large cap stocks. Mid-cap stocks are 12% and approximately 6% of assets are in small cap stocks.
A key attribute of an index fund is fund expenses. The VTSMX has a ridiculously low cost of 0.14%. This 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, the VTSMX Index Fund also offers tax efficiency. This tax efficiency has nothing to do with paying lower taxes but about disciplined investing. Index funds don’t resort to practices that require paying capital gain taxes. The VTSMX Index Fund accomplishes this by keeping the turnover at just 3%.
Why are Index Funds so popular?
Index funds in the United States have gained popularity over the last decade. There is a 300% growth in amount invested in these passive investing instruments over 10 years. 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 we live in a world where everyone tries to beat the stock market.
Index funds comes with an underlying principle that it is very difficult to beat the market. Hence, by construct, index funds never beat the market. Instead, they beat up most actively-managed funds real bad in terms of offering relatively better returns.
Let’s see some numbers.
Performance of funds over the last decade
In the last one decade, 85% of large-cap mutual funds ended up underperforming the S&P 500. And the study reveals, when extended to 15 years, that 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. This 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%. And 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 comes out to be a substantial gain for an investor. Low expenses funds can help investors make substantial gains.
Importance of low expenses in an index fund
Let’s understand this with an example.
Say you invested $10,000 for 30 years and your annual return was 10%. After paying 0.09% in expenses every year in an index fund, you would have accumulated about $1,700,000 over 30 years.
On the other hand, say if you have invested in an actively-managed mutual fund. This fund has an expense ratio of 0.82%. Assuming it delivered the same 10% pre-expense return, 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 understand. The investor need not worry about allocation amongst different market capitalizations or choosing a fund manager
- Diversification. Index funds are more diversified than most actively-managed mutual funds. That’s because indices pack in many stocks that fit the index categorization criteria. For example – 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. Often, they 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. This eliminates the risk of under-performance due the fund manager’s competence
- Better performance. Index funds tend to perform better than actively-managed funds over the long run. This is questionable and debatable. Over the last 10 years, 85% of actively managed large-cap funds have underperformed their indices in the US. Similarly,. 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. This style 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. They would let investors in only after ensuring they get a big slice in investment fees. The fees were a full percentage point (1%) or more as compared to the much smaller fees we see now.
Jack Bogle drew inspiration from the “Efficient Markets” theory. The theory 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 could only react to new information.
Using this simple insight, Bogle created a completely new philosophy of investing.
Bogle’s New Philosophy to Investing
Bogle’s index fund philosophy was built on keeping costs at its lowest
This cost management was done in multiple ways –
- Keep portfolio turnover low (at 3-5%) to reduce brokerage and taxes. In comparison, 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. All these added up to the net returns to the investor.
As a result of Bogle’s vision, the expense ratio for Vanguard’s funds is 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 in 2019 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 ₹7,700 crores. This is a small droplet in a ₹28,00,000 crores mutual fund industry in India.
The NSE and the BSE have certainly done their part by creating an array of indices. These are available in the equity and the fixed income side.
For a detailed understanding, refer to my post titled: “A Complete Investor Guide to Nifty50, Bank Nifty & 65 Other Indices”. The post covers how these indices are created, its constituents and composition.
Why Index funds are not distributed enough
Mutual funds in India have largely been an intermediary driven business. The product has been push sold 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, there is a lack of incentive amongst the distributor community to promote these instruments. The commission is very low because the expense ratios are minimal, often ranging from 0.10% to 0.30%.
The good news is that India has recently seen the emergence of direct plans being promoted through online platforms. The prominent ones are ETMONEY, PayTM MONEY, Groww and Kuvera. These platforms 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 have strung periods of over-achievement and under-achievement as compared to their benchmark indices. However, consumers tend to ignore these in their calculations. They tend to chase only the returns column of mutual fund tracking websites and apps. As the investor matures, he will give emphasis to risk and returns while evaluating mutual funds.
Since the average Indian chases returns he often buys an actively-managed mutual fund that’s doing better than benchmark, holds on to it until the fund performance goes south, redeems it and replaces it with another fund. This pattern makes the average Indian is worse off as he buys when the price is high and sells when price is low.
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. The report 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. This is done over a 1 year, 3 year, 5 year and 10 year period.
The study looked at the under-performance to benchmark for actively-managed funds. This underperformance was 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.
Mutual Fund versus benchmark
Now, let’s also examine how the average mutual fund has performed against it’s benchmark –
We see that on most discrete periods, the benchmark performed better than the average mutual fund. This was seen across large, mid/small, ELSS, government bond and corporate bond space.
Further studies elsewhere have raised expectations that this underperformance from actively managed funds is bound to continue over time. This means mutual funds esp. large caps will find it difficult to justify their fees.
Infact, this trend of equity fund under-performance is not specific to India. Even the SPIVA report for the United States shows that 78% of large cap funds in the United States have underperformed their index over a 5-year period. The variance is even greater 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. 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
Additional Resources You Might Like
Here are some articles you might like:
- Rakesh Jhunjhunwala and his secrets to investing (Part 1)
- Building a high return portfolio with index funds – a step-by-step approach
- Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
- The trillion dollar index fund story that John Bogle started in the 1970s
- Best SIP for achieving long term goals