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How index funds lead to mediocre results at the best

Updated: May 7

These days there is a constant debate as to whether one should start investing in Index funds as compared to actively managed funds. Few of the reasons are the burgeoning index funds in the western markets, under-performance of mutual fund managers as compared to benchmarks in the Indian context and the extremely low costs associated with these index funds. In fact, the investments in Index Funds/ ETFs have reached a whopping INR 1.8 Lakh Crore! ( Source: AMFI, Feb 2020)


After going through a lot of articles recommending index funds (in fact one was just published in the newspapers while I was writing this article), I tried to analyze if investing in index funds actually makes sense.



(Image source: Times of India)


I started by analyzing the composition of Nifty 50 (Feb 2020) and found some interesting results.


  • Over the last 10-year period, 24 companies have given less than 10% returns with 7 of them giving negative returns. Interestingly, most of the companies were in the Nifty index even 10 years back and are still there given their sheer size.

  • 8 companies have a negative EPS CAGR in the last 5 years comprising 17% of the index!

  • 25 companies have a EPS CAGR of less than 10% in last 5 years. Effectively, in the last 5 years, 40% of the index had Earnings-per-share growth of less than 10%.

  • 13 companies are laden with heavy debt and have mostly given poor returns barring a couple of exceptions.

  • Half the companies have had an annual sales growth (loan book in case of financial institutions) of less than 10% in last 5 years.

Based on further analysis, I found that more than 60% of the companies are simply not worth investing. They have neither been able to generate good returns on capital, nor increase their sales and are laden with debt. Interestingly, all PSUs except one in the Nifty 50 index are in the bottom 30% in terms of returns and most other financial parameters.


Below is a snapshot of some key financial parameters discussed above for the companies currently in the index. The companies have been sorted as per their last 10-year annualized returns (1st column).

(Raw data source: An amazing tool - screener.in )


I have used very simple and easy to understand parameters here. Sales growth in last 9 years/ 5 years. Earnings in last 9 years and earnings per share in 9 & 5-year period. Return on Capital employed shows how well the company has been able to utilize its funds and the Debt ratio shows the amount of debt the company has as compare to its equity.


As can be seen, all the companies which have performed well in terms of sales and earnings growth and managing their capital have given excellent returns as well. On the other hand all of the high debt companies have given moderate returns at the best and none of them figure in the top 10. The companies which have not done well are the companies which have failed to generate returns. Observe how all the parameters are green in the companies generating the best returns and how the entire table turns red as you do down.


Given the quality of businesses present in the index fund, it becomes a no-brainer that investing in index funds/ ETFs doesn’t make much sense unless you are happy with mediocre returns. An index fund like Nifty 50 is simply made up of the top 50 companies with the largest market cap and does not consider any other aspects of the business.


Below are few reasons why index funds are generally suggested and why they don’t make much sense


Diversification


One of the reasons I have heard in favour of index funds is diversification. Indices like Nifty help you diversify across sectors and companies. My argument against this is why would someone need 50 stocks to diversify? On top of this one would further invest in a mid-cap index and diversify further into 150+ stocks with half of them junk.


Surely one needs to diversify but in the best performing sectors and the best of companies. In the case of indices, as can be seen from the Nifty snapshot above, we end up getting into a lot of companies which in most likelihood will not generate any returns whatsoever. A much better approach would be to pick the top 25 best performing companies and sit on them. One would still achieve all the diversification needed with much better returns.


Low expense ratio:


There are plenty of advisors out there who recommend investing in index funds because of the extremely low expense ratio - "Invest in low cost products to maximize your returns" is often heard. Some even go on to suggest that mutual funds with lower expense ratios should be preferred to get higher returns. This is one of the most absurd reasons I have come across. Till now I have not been able to find any evidence that just because the expense ratio is lower, it would translate into higher returns. The quality of underlying assets and competency and capability of fund managers is what matters and low expense ratio has very low bearing to the overall returns generated. I


A good fund manager with quality investments and higher fees would still be able to generate better returns than an average fund manager with poor investments no matter how low a fee he/she offers. In fact this point is very much pertinent in the case of index funds. The fees is extremely low but half the companies are simply not worth not investing hence leading to mediocre returns.


In order to reduce expenses, one should simply stick to direct plans and spend more time and effort in finding the best fund managers who can generate outstanding returns. This point further gets strengthened from the performance comparison of mutual funds with index funds given below.


Elimination of human bias/ fund manager related risk


Another point which is generally mentioned in favor of index funds is that they help you eliminate fund manager related risk and you are left with market related risk only. Basically you are at the mercy of markets here. While you eliminate fund manager related risk, you also end up eliminating a fund manager's expertise and potential to get higher returns. Simply because half the fund managers are not doing well doesn’t mean no one should be trusted. As mentioned earlier, a good fund manager should be able to avoid most companies which do not merit investment.


Index funds are good for risk-averse/ new investors

Again there is simply no basis for this. Whether you invest through equity mutual funds or index funds, you will be ultimately exposed to equities. The portfolio will have some degree of volatility either way. The best way to reduce risk is to invest in high quality, low debt companies which are able to consistently make money year-on-year or find funds which are investing in such companies. Also, if you are “investing” (and not trading) and want to create wealth, you need to have a long time horizon. A long time horizon averages out all the ups and downs of the stock market.


To illustrate this point further, below is a comparison of different large cap mutual funds with HDFC Nifty 50 Index fund for the last 5 years. All these funds mostly move in tandem with each other (as far as the volatility is concerned) as well as the Nifty index. However, the funds with a better portfolio slowly start out-performing the others.

(Source: Moneycontrol.com)



Under-performance of mutual funds


One of the other reasons which is gaining prominence is the under-performance of most mutual funds as compared to the benchmark. However, this reason is not convincing either and does not seem to have much basis. Just because more than half the fund managers are under-performing , doesn’t justify that one should be content with mediocre returns. By devoting adequate time and effort along with prudent research, one can still identify the best funds in the market. There are some amazing fund managers out there with excellent thought processes and amazing stock picking skills.

Below is a comparison of Nifty 50 index funds with large cap funds over a 10-year and 5-year period.


MFs in green have given higher returns than the best performing index fund. (Data source: AMFI)


Clearly, over a 10-year period, most of the mutual funds have generated higher returns than the index funds. However, the situation slightly changes over the last 5-year period. Only a couple of funds have out-performed. However, this is mainly due to the underlying assets of these mutual funds.


A quick look at Axis Bluechip Fund's Portfolio shows that they don’t own even a single PSU (Jan 2020). Most of their investments are in the top performing companies in the Nifty screenshot (the green colored ones). They have actually weeded out all the poor businesses to generate higher returns than the index.


The other funds like Aditya Birla, Tata, etc on the other hand have sizeable exposure to PSUs and low growth companies. Hence the relatively lower returns as well.


Given this minor under-performance, it certainly does not mean that one should start investing in index funds because these fund managers have not been prudent enough in their stock selection. The best recourse is to stay away from such funds/ fund managers and look for funds investing in good companies which continue to outperform the market.


Regular/ direct plans: Also, the above returns are given for Regular plans (ease of availability of 10-year data) which one should anyways stay away from. In case of direct plans, almost all the funds have outperformed the index funds.


I completely understand that most of us are extremely busy to be able to devote time to finding out the best companies/ funds/ fund managers. Many of us may not be financially savvy as well. However, in order to create long term wealth, there is simply no substitute to spending time and effort and doing some research. If we can spend 200+ hours a month in our jobs to get a salary, we can surely spare a few hours for our personal finances as well where the potential returns are much greater than any salary and can secure our financial future. Also, the basics are not very complex once you understand them. You don't really need to invest in any fancy financial instruments as well. I have talked more about this in my article here.


To summarize, I completely agree that Index funds provide a quick way to start investing (which is way better than idle money lying in FDs and Savings), however, by doing so you are settling for mediocre returns from the very beginning and robbing yourself of the vast wealth creation opportunities out there. Even a small difference of 1.5%-2% compounded over many years makes a huge impact in the long term.


Please do let me know your thoughts. Would love to hear your views and different perspectives.


(Disclaimer: Accuracy of data is not guaranteed. I have taken data from multiple external data sources. Dividends have not been included in the nifty index returns.

I am not recommending or advising in favor of/ against any particular fund/ stock mentioned above. These are my personal views only. I may/ may not have positions in the above mentioned funds/ equities. This article is meant for educational purpose only). If you liked this article, do subscribe below to get updates on new posts.

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