This is a random thought on my musings about why index funds outperform most fund managers and active investors. When I compare index funds with every successful long-term investor, there are three salient features. In fact, the seemingly “dumb” Mr. Index appears to be the smartest of all investors because it doesn’t think and simply follows winning strategies mechanically.
Ranking and Sizing:
Mr. Index always ranks the stocks it holds and allocates based on these rankings. The highest allocation goes to the top-ranked stocks. It never does equal allocation nor allocates to thinly in best ranked stock.
Let Winners Run:
Mr. Index will never reduce its stake in a winning stock, regardless of market conditions or price fluctuations.
Quick to Weed Out:
Mr. Index is emotionless when it comes to removing losers. It completely removes stocks from its portfolio when they fall out of the ranking.
So if you really think, THE only edge an investor can have over an index fund is a better RANKING mechanism, remember that it is impossible to be as mechanical as an index fund in other aspects. Ranking stocks is definitely a challenging task, but Mr. Index uses a simple formula based on market capitalization and still outperforms almost everyone.
Index investing does have its merits, and it is becoming hard for managers to beat indices, particularly in the large cap space, but there are times when index returns lag active funds’ returns, they don’t outperform every single period. For large cap, it is almost true, except for intermediate terms. And when they fall, they will fall they will be in a free fall, as there is no intervention, there is no damage control.
And, we have equal weighted indices too, which have their own advantages. One can choose these so as to not tie the returns to a handful of stocks. Rebalancing is also done relatively late.
And by active investors, if you mean direct equity investors, there are all kinds of investors. Some may not beat the indices, some can beat but the effort is not worth the alpha, and some will beat consistently as individual stocks possess the quality of becoming multibaggers. And retail participants have started to build their own systems and models, these while come with bigger drawdowns also have the potential to deliver returns that are beyond the scope of indices.
Index investing does suit people who value their time more than the return, who have time on their side, who can sit through underperformance without comparing their return with active funds, who believe in the growth of the overall market, not just some pockets etc.
Yes, there are savvy individual investors. I am trying to dissect why a normal retail investor lags an index. Mostly it is either or all of the three reason that I listed. That is, they either they do not allocate well or they sell too early or they sell too late. Index has no such bias. It is mechanical as it is based on formulas with no motion. Even the best of investors wont be without biases and some level of emotional connect. Where best investors consistently beat index is only because they have better universe of stock than index. Which is the ranking problem that I described.
Investing is a broad umbrella, different kinds of people participate differently, even if there is data, some things cannot be quantified. Generalization beyond a point does not present the entire picture. Also, when one is an active participant and gains experience, he can change his views completely.
I am not sure if you have gone through the forum. Investing is not unidimensional. There are many facets to investing than just picking better stocks.
Well, as of today and more importantly going forward, it will become even more difficult for active investors ( and fund managers ) to beat a basket of indexes. In the past, index investing meant investing in our primary broad based index ( Nifty ) but we now have a wider range of indexes that has now a better Ranking mechanism and scans through a bigger universe.
In my view, anyone actively deploying money in a basket of stocks will need to do something significantly out of the ordinary and at the same time will need some luck on his/her side. I honestly dont see a lot of fund managers outperforming a basket of indexes going forward.
A Sample basket of indexes that I think will be very difficult to beat →
Nifty Large MidCap Index
Nifty 200 Momentum 30 index
Nifty Midcap Momentum 50 index
Having said this, the edge that investors like us have i think has narrowed down to either of the following 2 approaches
Having an even better Ranking mechanism alongwith optimum exit criteria ( for those who want to have a basket of stocks ).
Find the most lucrative steals in the market and go all out on those. Large allocations to a small group of hidden gems.
I will be keen to know if anyone can list out any other edge that individual investors might have in the current/future regime.
I would say, each investor is different, each one’s story and path are different, and while not necessarily called as an edge, one can have something like experience, temperament or wisdom which can lead to better outcomes as opposed to the outcomes without them. And if one is doing is by himself, I don’t think he would compare his returns with anyone or any fund, unless he’s losing interest or when time becomes scarce. Many ways to skin the cat, and we all use different tools to do that.
As with the multitude of indices that are created, I think the real time returns of these indices are to be considered and not the base date.
Stock returns are positively skewed over an extended period of time. Randomness holds [bell shaped normal curve] only on the first period. Sharing the graph from Farago- Hjalmarsson study of 2022-
It happens because good investors of one time period has a better chance of doing good in next periods (to hell with the efficient market hypothesis). Well, ultimately the return curve over an extended period of time looks like 80-20 curve (power curve). Hardly 20% of investors can beat the average.
Even among the 20% winners, power law operates. 80% of those 20% can merely beat the market with 1-2-3% margin which may not be sufficient to take the stock picking endeavour. 4% of the investors [20% of 20%] can beat the market handsomely, 1% can be extremely extremely successful and a few will be outliers like Rakesh Jhunjhunwala.
Thus, most of the people not beating the index is a statistical certainty.
The statistical certainty is because of statistical distribution of behavioural biases. This is what what I am trying to dissect here. What are those methods of Mr. Index that make it an outlier among individual investors.
Well, in a positively skewed distribution Arithmatic Mean is greater than Median. This, a large population will always be less than Mean. Index has been defined as mean, and hence it beats the majority. Define index in terms of median and index will underperform. Index is good because of this definition.
Yes, nature of index like higher weightage of winners, cutting the losers, buy and hold strategy, 100 percent investment at all times are certainly good investment strategies.
I think one the reasons etf are safer than mutual fund is that purchase of DII affects the stock itself.
If some fund manager sells some company’s shares then it becomes headline in news websites triggering further selloff. Plus to sell such huge quantities they don’t have much liquidity during crash times, they have to compromise by selling lower than market price.
It becomes more difficult when your buy and sell activity is affecting the stock price itself.
One big drawback/con about Index funds is that they are forced to carry the stock even if there are any adversities pertaining to discovery of fraud, Corp Gov issues. The index will take them out only after the Golden window to save is gone by then active funds would have made a swift exit, but the passive funds continue becasue it is part of index.
Just another perspective: Direct stock investing is also helpful in case of dividend investing as a strategy. There are investors who want cash flow as well as capital gains without any redemptions. Not possible in an index fund.
My limited understanding is that in india etfs don’t give dividends whereas in the US etfs do give dividends.
PS: And it’s not the same as selling a few units as a proxy to dividends
Direct stock investing for dividends is not a good idea. Regular income can be generated through capital gain too, in etf or any index mutual funds; through systematic withdrawal plan. Dividend distribution by companies is erratic, it can be more or less than the required cash flow; can come when cash flow is not required and cannot be increased or decreased as per the requirement. In systematic withdrawal plan, one can do it easily. Further, systematic withdrawal plan is more tax efficient; on dividends you pay marginal rate of taxes, in systematic withdrawal you taxes only on the capital gain part which is taxwise more efficient.
