An Index A Group of Stocks That Reflect the Mood of A Market or A Segment Thereof
AS THE bellwether stock market index sensex crosses the 20,000 level and soars towards new highs, the fund management industry is breathing a collective sigh of relief. We haven't had much good news in the last one year, and it has been a tough sell to investors. At every point in time, investors were waiting for it to become cheaper. At 8,000, it looked like reaching 6,000. At 10,000 we waited for 8,000 and as it galloped past 11,000 and 12,000 we decided we had missed the bus and so would wait till things became cheaper. People are like that… at 40% off, a dress or a jacket looks cheap.
But stock markets are a funny thing: At 40% off, a market looks ready to head for a 70%-off fire sale. At a stock market fire-sale, I am afraid we would see only sellers, not buyers.
Fund managers are the High Priests of the Stock Markets; except the really brilliant ones, who tend to be humble people with no claim to divine and exclusive knowledge. They know that the real probability of success when making a trade is roughly 50%. That's because a price can move in only two directions in the short-term up, or down.
Which brings me to index investing. What is an index? It is a group of stocks, selected by an independent body of professionals to reflect the mood of a market or a segment thereof. Thus:
1. An independent body of professionals calculates factors like liquidity, representativeness of a stock of its industry, size (price x number of stocks) of the total number of stocks of that company that are available to the investing public ("free-float market cap") in determining the suitability of a stock for an index.
2. Then they compare it with similar stocks in the industry on the above parameters and pick the ones at the top of the list on the basis of the weighted average of those parameters
3. They look at industry factors to determine which industries must be represented in the index
4. Then a basket is created that has stocks (and consequently industries) in the ratio in which the independent body feels the market would be best represented.
5. Every quarter or so this body of professionals re-visits their assumption and decides to add, remove or re-balance the companies that they have chosen.
What is an index fund: it is a fund that invests in the exact proportion determined by this independent body in each and every one of the stocks that are present in the index. Such a fund must have a very good dealer (that is, a person who buys and sells stocks) but does not need a fund manager.
Index funds are meant for the long-term investor, it is said. In my view a long term equity investor is a person who buys equity like our mothers used to buy gold–buy it when you have the money; sell to meet an emergency or to buy a longer term asset, like a house or a married life or an education for a child!
Anyone who invests or disinvests by timing the market is not a long term investor.
The key risk that a long-term investor runs, when investing in equity is either that the company he chose becomes a non-performer or the person who chose it for him becomes a non-performer. The greatest advantage of an index fund is that you have to worry less about such events: the index committee or agency, whose members may change but whose processes are person-independent, takes care of such developments on an on-going basis. They do not take the decision based on hot tips or broker influence and are not affected by the departure of that divine fund manager. Which is why, as markets become more and more efficient, most long term investors prefer to invest in index funds.
The second advantage stems from the first: as a long term investor, you know markets will move up and down many times before you withdraw your money. But a SIP taken in a booming market (like today's) can often be a casualty, because the great star fund manager may not survive the next bust…. Or his fund may never again see its glory days. An index fund has no such problem; it moves in tandem with the index. So you may have bought at a high NAV when you started your SIP, but your rupee cost averaging will be most efficiently done, as the index will fall, and then raise and so on. The best thing is that in an emerging market like India, you know that the next high will be always higher than the previous high, whenever it comes.
Finally, an index fund is the cheapest way to buy equity. Even by regulation, index funds have to charge a lower fee; almost 40% lower than the active funds. Index investing is like praying to God of the markets without a priest… it may be less satisfying, but it is more economical, more heartfelt and indeed achieves the same results.
Happy investing.
