Disproving Arguments Against Index Investing - II : What The Data Has To Say

In last week's post Disproving Arguments Against Index Investing - I : Basic Misconceptions, I covered arguments against the basic concept of index investing. Today I will cover arguments born from an incorrect understanding of the construction and data pertaining to index funds.

Some Actively Managed Funds Beat The Market Over The Long Term

The most comprehensive source for realistic mutual fund performance data in India is the SPIVA India report. It offers an unbiased comparison of the performance of actively managed mutual funds against their benchmark indices. It also provides an indication of the performance of passively managed index funds in that region. As per the latest available SPIVA India report, 70% of actively managed Indian large cap funds, 75% of ELSS funds, 75% mid and small cap funds, 95% of composite bond funds and 85% of government bond funds have underperformed their benchmarks. This is borne out in this graphic taken from the report.

There are three major reasons why most actively managed funds underperform their benchmarks. The first of these factors is the absence of information arbitrage. Anyone looking to outperform the markets must have superior information and insights relative to other investors around them. Most fund managers within the industry all have access to similar information and insights. So the performance of most active fund managers in the industry would be similar to each other.

This means that there is no inherent source of outperformance available to active fund managers. Fund managers who lack competence would naturally be decisively beaten by benchmark returns over a period of time. So the only source of outperformance available to a competent active manager today would be the underperformance of other active managers around them. This means outperformance achieved by active fund managers has more to do with luck than the skill of the active manager.

SPIVA reports also offer a persistence score. Where an actively managed fund in any category beats it's benchmark index in a given period, SPIVA reports check to see how consistently that particular fund has beaten the benchmark. It has been found that an actively managed fund that manages to beat its benchmark, only does so by a small margin. It has also been found that the outperformance is not consistent.

The second reason is the skewed nature of stock returns. It is also important to remember that while the maximum downside for a stock is 100%, the upside is limitless. Moreover, only a select set of stocks within an index are likely to beat the index over a period of time. So long term stock returns may not resemble a bell shaped curve which is representative of a normal distribution. This invariably means that stock returns do not cluster around the average or median return. They usually tend to be skewed, most often towards the right.

This means that active fund managers would have to identify these stocks in advance during each period. They would also have to gain adequate exposure to them in their funds. This is the only way they would be able to outperform the index. But this is extremely hard to do correctly and consistently. And this points to the recurring conclusion that outperformance in active funds is extremely hard to achieve and sustain.

The third reason is the costs associated with actively managed mutual funds. Direct plans of actively managed mutual funds usually cost between 0.6% and 1.2% per annum. Direct plans of a Nifty 50 index fund cost 0.2% per annum. These differential costs of 0.8% to 1% per annum can significantly eat into our investment returns over longer horizons. To understand how this happens in detail, have a look at my earlier article Tactics Used To Hide The Truth.

The higher costs associated with active funds are meant to compensate the fund manager for his skills. But as shown by any SPIVA report, active fund managers achieve outperformance more through luck than skill. And they cannot sustain it when they achieve it. So investors compensate their fund managers for something that very few do well (if at all). This just proves that parking money in active funds is a raw deal for investors.

There Is Scope For Alpha Generation With Active Mid And Small Cap Funds

The data in most mutual fund performance reports is affected by survivorship bias. Most such reports only evaluate the performance of mutual funds that were in existence for the entire period of study. But this may not necessarily represent a true and fair evaluation of performance. A number of mutual funds may have gone out of existence during the period of study. And data on such mutual funds is not included in the results of most studies.

SPIVA report data accounts for the performance of mutual funds that went out of existence during the period of study (if any) in each category. This effectively eliminates any survivorship bias in the data. When studying data regarding mid and small cap funds in India, SPIVA has faced a peculiar challenge. It was found that a considerable number of mid and small cap funds had gone out of existence during the period of study. Therefore SPIVA India did not have enough data points for the purpose of the study to arrive at a statistically valid inference.

They therefore had to combine mid and small cap funds into a single category. A composite benchmark index (S&P BSE MidSmallCap Index) had to be created. Benchmarking mid and small cap funds to such a composite index does not always give a realistic picture of performance. Therefore it is hard to draw statistically valid inferences regarding the outperformance of mid and small cap funds in India.

Index Funds Distort The Prices Of Stocks In The Index

All index funds do is to track the price of the stocks composing the index. No forced buying and selling is required except in the case of semi annual rebalancing and corporate actions. This is why index investing is also called passive investing. The fund manager simply invests whatever money they recieve in proportion of the prevailing market cap of the stocks at that point of time. The proportion of free float of each stock purchased in an index fund can be given as below

Assume the total AUM of an index fund at a given point of time is Rs 10,000 crore. Assume the total market cap of all index stocks at that point is Rs 10,00,000 crore. Therefore the index fund would purchase 1% of the free float of each stock in the index [(10,000/10,00,000)* 100]. It is that simple. Therefore there can be no question of index funds distorting the prices of index stocks. It would also be wrong to say that index funds buy more stock of companies having significant weightage in the index.

The Last Word

I have covered most of the major arguments against index funds over the course of this article and the previous one. These articles are in no way an attempt to make index investing look like a foolproof strategy. No investment strategy can be termed as such. The simple objective here is that those who wish to follow index investing must know that the major arguments against index funds can be logically disproven. Critics of index investing can still find perfectly plausible arguments against index funds. But the ones discussed across these two articles are definitely not among them.