Index investing’s a good option at any point

The most cost-efficient way to generate market returns and even beat it (by timing one’s entry and exit) is by investing in indices.

In India, the two main benchmark stock indices are the National Stock Exchange S&P CNX Nifty and the Bombay Stock Exchange Sensex.

Those who invest directly in stocks or indirectly through asset management companies aim for returns that are over and above those given by these indices.

However, in trying to generate ‘alpha’ - or returns above the index returns — investors take a significant risk in terms of stock and fund manager selection.

They can lose much more than they can expect to gain if the stock  or fund manager selection goes wrong.

True, highly skilled investors can outperform the indices by a wide margin by taking concentrated bets on a few select stocks. Examples of such investments include Infosys and Wipro in the 1990s and Bharti Airtel in the early 2000s.

The fact that most of the investors in the markets have not fully captured the gains in individual stocks such as Infosys, Wipro and Bharti indicates that identifying and placing concentrated bets on winning stocks is not an easy task.

Hence, investors are better off taking in gains on such stocks by investing in the index when such shares enter the index, at the cost of other non-performers.

Benefits of index investing:
1. Diversified portfolio of some of the largest companies in the economy
2. Liquidity high as all segments of investors, retail and institutional, trade in the index in cash or in the derivatives segment
3. Tracking is easy as indices are given prominence worldwide
4. Top down (looking at macro factors) and bottoms up (looking at sector or stock specific factors) approach both work in index investing
5. Timing of entry and exit much easier than in single stocks

Risks in index investing
1. Opportunity cost of not investing in the best-performing stock if it does not belong to the index
2. Performance will suffer if stocks with high weight do not do well
3. Speculation on derivatives can pull the index in different directions
4. Constituents of the index are wrongly chosen
5. Liquidity driven buying or selling the index can increase volatility

Why index investing
Let’s take an example. Investor X has been advised by his financial advisor that equity markets are likely to do well in the medium to long term. The investor has to decide between putting money into individual stocks and mutual fund schemes or investing in the index directly.

To invest in individual stocks, there is a need to study the fundamentals of the economy, sector and the stock.

To invest in a mutual fund scheme the investor, apart from looking at macro and micro fundamentals, has to study the objective of the scheme, the calibre of the fund manager, the infrastructure of the asset management company managing the scheme and the portfolio of the scheme.

If it’s the index, the investor has to primarily look at macro fundamentals. Investing in the index enables the investor to execute his or her views on equity markets in a seamless and cost-efficient manner.

It is cost-efficient because expense ratios of index funds or exchange traded funds (ETFs) are the lowest in the industry (below 1% and much lower in many cases) whereas actively managed equity funds have expense ratios of over 2%.

Index investing can be done by buying the basket of stocks comprising the index (not recommended as it involves carrying thirty or fifty individual stocks), investing in index funds (recommended for investors who do not have stock trading accounts) or ETFs (recommended for investors having stock trading accounts).

Index investing does not incur entry or exit loads
(index funds do not charge exit loads as index stocks are highly liquid). Investors who want to invest regularly in
equity markets can opt for investing in index funds or ETFs rather than going for systematic investment plans in mutual fund schemes, as the latter is subject to higher costs, entry and exit loads and fund manager performance.
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