Is Higher Cost of Active Management Justified in Indian Context?

You know about index funds. Right?

Passively managed, these funds replicate the index at a portfolio level. So if the index has 50 stocks with different weightages, the index fund will have the same stocks in same weightages.

Since this type of portfolio maintenance doesn’t require any superior intellect or stock picking abilities (after all, it’s simple replication of an existing index), the costs associated with index funds are much lower than actively managed funds. Obviously, the returns of these funds mimic those of the index. So where most investors want to beat the indices like Nifty and Sensex, index funds don’t want to do that. They live by the motto – If you can’t beat them, then join them.

But we need to give credit where it’s due.

Index funds don’t beat a good fund manager. But surely beat the bad ones. 🙂

Now Mr. Buffett is a staunch supporter of Index Funds. And so are many other great investors and money managers.

In fact, when Google was preparing for its IPO in 2004, the company realised that a number of its employees were about to become millionaires.

Therefore, the company brought in a series of financial experts to teach them to make smart investment choices. Stanford University’s Bill Sharpe, winner of the 1990 Nobel Prize in economics said, “Don’t try to beat the market.”

Even he advised Google employees to park their money in index funds. And rightly so.

In developed markets like the US, 70-80% of actively managed funds fail to beat the indices. So, it’s really tough to find good fund managers ‘there’ who will beat the index on regular basis. Even if there were a handful of such managers, new money flowing into their fund coffers will ensure that their returns suffer when the fund swells up. Then again, it would be tough to find index-beating returns.

This is the reason that greats like Buffett advocate index investing.

Active managers can’t beat the index. And they also charge higher. So what’s the point of having active management? Isn’t it?

Investors should get a better deal.

In his latest letter to shareholders, Mr Buffett even talks about his bet that no person (whosoever) could select at least five hedge funds (high-fee investment vehicles) that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees!

Many investors tend to disregard investment fees. But when active management is not helping get higher returns, why pay higher fees for underperformance? Better stick with low-cost index funds. And in this age of robo-advisory, it’s possible to invest passively with minimal human interaction. And one look at any automatic investment fee calculator would highlight the amount of money that can be saved by going the robo-way. Low cost, potentially better performance. What else do the investors in developed economies need?

But here in India, the landscape is very different.

Many years back, I was of the view that I should be investing primarily in index funds.

But then I realized that index fund investing is not the best option for me. And for all those who are ready to take some additional (but not illogical) risk in need of higher returns.

There is enough proof available that active funds managed by good, skilled and capable fund managers in emerging markets (with not very mature equity markets) like India will outperform the indices.

In any case, if you tell someone in India that a fund will give you returns that match that of the index, they will be disappointed. Even if the index is giving 20% 🙂 Investors just want to beat the shit out of index returns.

But jokes apart, for most common investors it’s better to avoid index funds for time being.

A reasonably good proportion of mutual funds have been known to outperform the benchmark indices on a consistent basis over various time periods. In all likelihood, the index funds in India will be unable to beat some of the good actively managed mutual funds for some years to come. Here is an interesting analysis on active management (index vs actively managed funds) in India.

Some feel ‘Invest in the index for better returns and lower fees’ is Buffett’s Single-Best Piece Of Advice for common investors (who have no business picking stocks or fund managers).

It’s of course essential to control (if not eliminate) your investment fees. Uncontrolled investment fees can significantly reduce returns over time.

But given the Indian context, where the probability of finding index-beating funds is higher, the higher fund management costs seem justified. At least to some extent.

Finally, when it comes to index vs active discussion, I think we Indians have won the ovarian lottery (in words of Buffett).

We have quite a few options beyond index funds.

Index investing isn’t meaningful for most investors. At least not for me. At the current levels of market efficiency and size, I expect good actively managed funds to generate alpha atleast for next decade or so. Possibly after that, the over-performance (above index) might reduce as domestic equity markets become more efficient.

So as long as the party is on for some more time, keep dancing. 🙂