Setting Sights On Index Funds
With many new investors in the fray now in the wake of the pandemic and the irregular movement of the markets, there are some who have doubts about whether choosing index funds would be the right choice in such a scenario. The following article provides some insights
The corona virus pandemic has shocked the whole world. It is one of those ‘black swan’ events impacting not only the physical lives of people across the globe but also creating financial doldrums. The initial reaction to the pandemic was so severe that it sent the stock markets around the world for a free fall. Within a couple of months, equity indices dropped anywhere between 20-40 per cent. From its all-time high of 42,273.87 as on January 20, 2020, the S & P BSE Sensex broke below the 26,000 levels and registered a low of 25,638.90 in just two months. Nevertheless, the month of April 2020 witnessed good recovery and the S & P BSE Sensex is now very well above its psychological level of 30,000.
However, despite this recovery, the S & P BSE Sensex is still down by around 20 per cent on a year-to-date (YTD) basis. This sequence of a dramatic fall and an even more dramatic recovery in just a matter of months has led many people to re-think about investing in equities. Anecdotal evidence suggests that brokerage firms are witnessing record opening of trading accounts over the past two months. The same is true for the mutual fund industry that has seen a surge in the number of folios. While many of them are still undecided about where to invest, some are wondering whether index funds would be a better choice than actively managed funds. As such, in this article we would try to find out whether it is the right time to invest in index funds and also explain the advantages of doing so in such times.
As can be seen from the above graph, S & P BSE Sensex fell from its all-time high to create a low near the 26,000 level and then recovered. Currently it is consolidating above the 30,000 level. Many people ask whether the markets have bottomed out and the trough is behind us. The answer to this question can only be given in hindsight. But yes, historical evidence suggests that such recoveries many a times are not sustainable. Therefore, there are chances that the markets would correct in time to come.
An Irregular Recovery
Needless to say, markets do recover after a fall. It’s just patience that you need to hold on to. Even historically, markets have witnessed such extreme falls and have recovered. Let us look at such scenarios so as to increase your conviction towards investing.
The above graph indicates that each fall is followed by good recovery and indeed history repeats itself. Therefore, even if the markets have nosedived, going ahead we will definitely see recovery taking the upper hand. Even though the intensity of the fall this time around is quite high, there is a chance that the recovery phase will see better returns. Hence, investing in such a choppy market would help you to create good amount of wealth when the markets recover. As of now, therefore, investing in the markets with patience as your prime virtue makes sense.
Current Situation
Though the bear market has affected most of the cyclical stocks such as banking, NBFCs, metals, automobile and ancillaries, among others, within this fall the impact is fairly different for different stocks. And how the stocks would recover from the bear phase will mostly depend on their business models, quality of management, market leadership and how strong they are financially. Currently, we are in a very complex economic situation and even the market is quite volatile and fluid. Hence, it would be difficult to identify stocks that will sustain in this environment and ensure recovery. Given this scenario, we believe that investment in index funds is the most prudent thing to do for conservative investors.
False Recoveries
The frontline equity indices and many sectoral as well as broader indices are up by more than 25 per cent from their recent lows. So this may create a false perception among investors that we are on the path of recovery. But that may not be the case.
As can be observed from the above graph, during the global financial crises in 2008 we had many such false indications of recovery. This means that even though the markets bounced back, they were still in the bear phase. As we all know, the stock market journey is never a straight line – it’s either in a bull or a bear phase. Hence, even in the current scenario we may see such false recoveries. The following graph would give you more insights about the current situation.
It is observed from the recent fall that there has been an upside move close to 15 per cent in just a matter of three days. Recovery never happens in a single straight line. We might see more such false recoveries before actual recovery begins to take shape. Hence, we should not fall prey to such false movements. Rather, we need to take a more disciplined, systematic and focused approach while investing. This can be achieved by investing in index funds.
Right Opportunity
At any time when the market starts to recover, initially it will recover quickly and then slow down before attaining a sort of normality. This can be seen in the following graphs.
The above graph shows that when the S & P BSE Sensex started to recover post the global financial crises, in just matter of 60 trading days it gave around 90 per cent returns on an absolute basis. However, it took 336 trading days to generate 34 per cent returns on an absolute basis. In around 13 months of recovery, the S & P BSE Sensex gave 154 per cent on an absolute basis. Same is the case with the mid-cap and small-cap indices wherein in the initial 56 trading days it recovered almost 111 per cent and 120 per cent, respectively. However, if you look at the time taken by large-cap, mid-cap and small-cap indices to reach their all-time highs, it is the Sensex that took less time compared to mid-cap and small-cap indices.
The Sensex took around 396 trading days as against 471 trading days taken by mid-cap and small-cap indices. From this we can say that any delay in investment might cost you a lot. Having said that, presently we don’t know the bottom and no one can predict the same. Hence, it is better to start investing in index funds via a systematic investment plan (SIP). If you wish to invest via lump sum then park that amount in a quality liquid fund and start a systematic transfer plan (STP) in index funds. With this you would be accumulating a good number of units while ensuring that you don’t miss the initial recovery.
The question is why should you invest in index funds now?
Here are the reasons:
✔We are currently in a bear phase that is caused by a severe health crisis and which in turn has led to an economic crisis in the form of lockdowns. Hence, we would see recovery when there is concrete treatment for this virus. Though many medical institutions have started human trials on their developed potential vaccination, there is still no guarantee whether it will work or not. Hence, in the near term the markets would be muted or might even fall further. In such extreme circumstances, having a stock-specific view can prove to be very risky. This can be seen from the table below:
The above table shows that in the past three months, almost 64 per cent of the companies forming part of the Nifty 100 index failed to outperform the index. We can even see a similar thing in the Sensex. The graph below clearly explains the same. 
As observed, more than 50 per cent of the companies forming part of the Sensex are not able to beat the index. Hence, having a stock-specific view can prove to be risky. Therefore, this serves as a good opportunity to invest in index funds.
✔We have seen many actively managed equity funds struggling to beat their benchmarks. Even though these funds strive to diversify by taking stock-specific calls to generate alpha over the benchmark, fund managers might be overweight on certain stocks with respect to the benchmark index. Looking at the current economic scenario, if the fund managers’ calls go wrong, then such funds may underperform. And we can already see this happening, as can be gleaned from the table below:
The above table clearly shows the inability of the active funds to beat the index in the current scenario. In the past one month, only one fund was able to beat the index and that too just by 0.04 per cent. Even in a three-month period, only 12 funds out of 35 were able to beat the index. Hence, investing in index funds would be a better investment option as this will help you to avoid fund managerial risks.
✔During previous recoveries from the bear phase, the heavyweights of the S & P BSE Sensex and Nifty 50 were the ones that started recovering. The frontline equity indices have the biggest companies from the sector. These stocks would perform well in the current situation and during recovery. However, some might argue that taking a contrarian approach by investing in sectoral funds that are beaten down the most now would be a better option than investing in the index as it would be rewarding. Historical returns from the sectoral funds do not prove this.
In the above table, those highlighted are the ones that were the top performing sectors in respective years. So, as we can see, no sector performed consistently. Even if you are thinking of taking a contrarian approach by investing in sectors that are beaten down, then you would surely be in a losing position. Say, for instance, in 2013 the worst hit sector was realty with negative 32.09 per cent returns. However, in the following year banking was the one that came out to be on the top. Hence, investing in a sector is indeed a risky venture. This is because one cannot say which sector is going to play out favourably the next time around. Therefore, it makes more sense to invest in frontline index funds.
Selecting Index Funds
There are only two simple parameters to select index funds. John Bogle once said that picking funds based on performance is likely to be a futile effort. And guess what? While selecting index funds, you don’t need to look at their performance.
❝ If you invested in a very lowcost index fund – where you don't put the money in at one time, but average in over 10 years – you will do better than 90 per cent of people who start investing at the same time. ❞
— Warren Buffett
Tracking Error : As we know, index funds are those that track the underlying index. Hence, while tracking, we may witness some underperformance or outperformance due to time lag in taking action. However, while selecting index funds you need to ensure that any such underperformance or outperformance is as much the minimum as possible. Lower the tracking error, the better it is.
Total Expense Ratio : This is the cost that you would be incurring for investing in a fund. This also affects your returns. Therefore, lower the expense ratio, better the returns. Therefore, rather than looking at its outperformance, check the expense ratio. While investing in index funds, you would have two options: one being the regular plan and the other being the direct plan even though the difference between their expense ratios is not more than 0.4 per cent. But in the long term, the difference in wealth caused by this can be considerably high. Hence, we would recommend you to opt for a direct plan.
Conclusion
Historically, there are lot of false recoveries that would tempt many of you to buy sectoral funds. In such situations, chances are high that your call might go wrong, resulting in underperformance with respect to the index. Also, the initial recovery of index post crises has been quite impressive. Therefore, to grab this opportunity it is recommended that you start SIP in index funds. However, those having lump sum amount can invest in a staggered manner. Remember, the value lies in the time and the returns.
Hence, ensure disciplined investing and timely actions. While selecting index funds, do look at the tracking error and expense ratio. If you are someone who is disciplined in nature and are aware of how to invest in stock markets, a good option is exchange traded funds (ETFs). ETFs are lower in cost depending upon the brokerage and their tracking error is way lower than that of index funds. Another thing to look for is the liquidity in ETFs. Liquidity doesn’t mean how many ETFs are traded. Here you would need to ensure that the underlying stock is liquid enough.