Index fund revolution in the US

In the USA there has been a mini revolution of sorts. Urged on by people like Warren Buffett himself, more and more people have gone to Index and ETF way of investing. Not very difficult to see why – performance.

Now consider a fund manager in the Indian context. He heads a multicap fund and has a choice of which company shares to buy. So he buys many midcaps – in say auto ancillary and a few sugar shares. He also picks up some large cap IT shares in his portfolio.

Do you think this is some big strategy? No. He has just stuck to the SEBI guidelines and his boss – the CIO’s instructions to pick up across 4/5 industries and 3/4 styles. So he has picked some value stocks, some momentum, some midcap, large cap, commodity stocks – actually at random.

He gets a very good out performance in the first year. Should he be lionised? well nobody knows. However, the fund has a huge PR and media budget, and they are hungry for Aum. Good combination, he gets a big surge in Aum. Now his moves are watched. He has no clue how to move. One big magazine called him “most focused multi cap fund manager”. He is now wondering what that meant. As there was no clear bench mark, he has no clue which fund to copy. When we met he asked about a couple of seed and fertiliser companies. He wanted to repeat in fertilizer what he did in sugar a couple of years ago.

Then suddenly the performance slipped. Analysis got better. Analysts did more research. A portfolio of stocks can today be systematically broken down into the factors that drive its returns -adjusting for the riskiness, size, valuation, recent momentum of a fund manager’s holdings, its out performance drops to a lesser percentage point! The worse problem is when you tell a group that “S has beaten the benchmark by 1.9% p.a over 23 years, people do not see it as impressive!  Even fund managers lionized in the past – like Mr. Peter Lynch can look LESS impressive with the newer analytical tool!

Two worrying trends – shrinking alpha, and over analysis.

Every fund manager’s performance looks like it is easy to replace the fund manager by an ETF or an index. Remember we now can create a Momentum index, High Growth, Foreign, Large cap – so suddenly the ‘alpha’ creator looks vulnerable. And the investor is not impressed because he does not understand that a 1.9% out performance over 24 years is awesome, and is more impressive than a 2.9% out performance over 3 years.

Sure some of the fund managers will perform way ahead of the market and generate alpha, but there is no justification for 42 fund houses with 800 fund managers and 18 ULIP fund managers to think that they will ALL out perform the index. Obviously by definition, they cannot.

Who was the economist who said 5 decades ago that your plumber could be a former fund manager? Well it is already happening in the USA. 2030 India will look similar.

Right now funds with 70% equity and balance in debt are out performing pure equity funds – showing that market timing is something best left to fund managers. While investing in a pure equity and pure debt funds, market timing HAS to be your skill. If you lack that look at investing in balanced funds.

Caveat: Fund houses have been hard selling and terribly mis-selling balanced funds. I am not joining he chorus, it is just that I have been a long term votary for a bal fund with 70% equity – if that is the ONLY fund which you wish to have. I have a 85 year old investor who has only one balanced fund, and he has been holding it in the Growth option for 17 odd years.

 

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One Response to “Index fund revolution in the US”

  1. K S Viswanathan on January 9th, 2017 at 2:54 pm

    Subraji

    The turn over in ETFs is so low india that one wonders whether this will improve. May be by 2030 it will be different

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