Why You Should Seriously Look At Index Investing
In the last 2 years, there has been a big shift towards passive investing. For instance, passive investing refers to allocating money to index funds and index ETFs, where the fund managers don’t take any direct view of the markets. Instead, they prefer to put money in an index backed portfolio, where stock selection is not required. One may wonder what is the idea of putting money in index funds. Remember, Sensex has given annualized CAGR returns of 16.5% over the last 43 years, excluding dividends. That is phenomenal returns for an index. At a time when fund managers often struggle to beat the market index, it makes a lot of sense to allocate some part of your funds to index investing. Here are some important reasons, why you should seriously look at index investing as a strategy.
Why you should seriously look at index investing
There are several advantages of investing in the index. Active investing looks great on paper, but in reality, it is tough to consistently beat the market. Also, as an investor, it is tough for you to find fund managers who will beat the market. That is why index investing makes a lot of practical sense.
- Index funds and Index ETFs are fantastic examples of passive investing. The portfolio mix of the index ETF reflects the index, which makes it simpler and more predictable.
- As stated earlier, indices can be super performers over time. Between 1979 and 2022, BSE Sensex has given 16.5% CAGR returns, excluding dividends, which is another 1.5%.
- The best thing is that index funds don’t have unsystematic risks. They only carry systematic risks. In short, the index is a naturally fully diversified portfolio.
- Alpha is what every fund manager chases, but it has often been elusive; in India and globally. Index funds or Index ETFs do away with the concept of alpha. Hence investors are saved from negative surprises.
- Index funds overcome human bias in a significant way. Most fund managers invariably let their personal biases come into their investment decisions. That is inevitable. In an index fund or index ETF, the only challenge is to track the index.
- The biggest advantage of an index fund or an index ETF is low costs. A typical active equity fund may have a total expense ratio (TER) of 2.25% while the passive index ETF would have a TER of just about 0.4%. This compounds returns much better over time.
- One argument is that many diversified equity funds are just a proxy for index funds. That is also a reason, why many of them don’t outperform. Then why pay 150-200 bps additional for such funds which eventually just about reflect an index portfolio?
- In India, the percentage of active funds that manage to beat the index is sharply reducing. If you look at recent reports, just about 10-12% of the funds beat the indices on a consistent basis. India is moving towards the US model, so a greater shift to passive funds is likely to get accentuated in India.
- Like the global markets, Indian markets are also getting more efficient and spreads are getting tighter. Going ahead, fund managers will substantially struggle to beat the index on a consistent basis. That is where passive funds and index funds fit in.
- In active investing, it is very difficult to distinguish between the skill of the fund manager and market support. That is where index funds and index ETFs just remove the bias from investing altogether.
The legendary Jack Bogle once said, “Why to look for a needle in a haystack, when you can buy the entire haystack?” Therein lies the inherent advantage of being an index investor.