Buying Sensex Like a Stock

For most of the investors, the movement in frontline indices like Sensex and Nifty represent performance of the equity market. If these equity indices are moving up, they believe, the equity market is moving up. Similarly, when these indices fall, they come to the conclusion that stock market is not doing well. Besides, there are few who consider their movement as a barometer of the Indian economy. Nevertheless, the experience shows that this is not always the case. The economy and the stock market can move in different directions. There can also be divergence in movements of the equity bellwether indices such as Nifty and Sensex and broader equity indices such as mid-cap and small-cap.

There are times when the movements in Sensex or Nifty hide more than what they reveal about the performance of the stock market. One of the best examples of this was during the Fed taper tantrum in the year 2013, where one could hardly see any movement at the Sensex or Nifty level, but at the broader level, companies' shares saw a huge erosion in prices. Sensex saw a maximum fall of 10 percent from its peak that year, while the individual portfolios and share prices of the companies were down by more than 30%. There were even cases where some of the index constituents were hitting their life-time highs, while others were trading at their 52-week lows. For example, the shares of some of the pharma companies such as Sun Pharmaceutical were trading at life-time high in 2013, while the other constituent of the index Tata Steel was continuously hitting its 52-week low.

History repeated itself few months back when the equity bellwether indices were touching life-time highs, but the individual portfolios were down by 25% within six months. The big lesson learnt from the above two incidents is that the frontline indices like Nifty and Sensex may perform even if other market segments like small-cap and mid-cap are not performing. 

What makes an index perform?
So, what makes equity indices, and especially frontline indices, perform? The history of the recorded equity market in India is not as long as some of the developed countries. The experience of these countries (developed markets) shows that beating these equity benchmarks is very tough and most of the actively managed funds could not do it on a consistent basis.

Even in India, the limited study shows that at least the large-cap dedicated funds find it hard to beat their benchmarks on a consistent basis. This has become even more difficult once these funds are asked to benchmark their returns against total returns index (TRI) that includes dividends, in addition to the price appreciation. From January 2018, SEBI has directed that all equity schemes must benchmark their performances against the TRI. All equity indices have TRI values that have dividends in underlying companies added back to the index value.

According to a report in March 2018, on a one-year basis, only 42% of the actively managed funds could beat their benchmarks, and this drops down to 5% if we take three-year performance. Segregating this market cap-wise, large-cap funds have not performed well and only a third have managed to beat the TRI version of the benchmark.

The reason why beating benchmark index becomes difficult because of their constituents. The benchmark indices are made up of leading companies. Moreover, these companies are from different sectors. Therefore, an index is made up of leading companies from different sectors.

The current composition of the Nifty 50 shows there are 50 companies representing 13 sectors. Some of the companies such as ITC, Tata Consultancy Services, Maruti Suzuki India are the leaders in their respective sectors.

Therefore, going by the modern portfolio theory, index offers a perfect diversified portfolio, which is made up of the best of the companies across sectors and industries. Hence, investing in index companies in the proportion they form part of the index gives you better returns.

Why Index or ETFs

Understanding that indices generate better returns in the longer term is easier. The difficult part is how to invest in indices. Despite knowing the fact that investing in the index companies can give you better returns, for an individual, it becomes very tedious to invest in these companies. First, deciding the proportion and then investing in individual companies will be a tedious task for any investor. Besides, it is also costly to continue with such investment process as old companies exit the index and make way for the new companies, so the investor will have to keep juggling between these companies. So, keeping track of such changes and aligning your portfolio accordingly makes it even more painful.

Nonetheless, there are certain easier ways in which you can take exposure to the indices. The easiest way is to use derivatives. You can also use derivatives to get exposure to the index in the form of future and options of the indices. However, these are short-term in nature, need specialized knowledge and may not suit your investment requirement.

Hence, investing in index funds or ETFs may help you to take exposure to the indices without undergoing much of the hassle.

What are Index Funds and Exchange Traded Funds (ETFs)?
Index funds, as the name suggests, invest in the constituents of an index. These funds purchase all the stocks forming part of the index in the same proportion as in the index. For example, if an index fund is tracking BSE Sensex, it will invest in all the stocks of the Sensex in the same proportion as in the Sensex. Therefore, this fund is likely to perform in tandem with the Sensex. These funds incur lower expenses than actively managed funds. For example, HDFC Index Fund – Sensex Plan has an expense ratio of 0.30 percent, whereas actively- managed funds may charge around 1 percent on direct plans and around 2 percent in regular plans.

An ETF is also like an index fund as the ETF too hold baskets of stocks in the same proportion (but not necessary) as the index it is following and the goal of the ETF is to mirror the performance this index. However, ETFs are traded on the exchanges just like shares of a publicly-listed company and hence these are known as ETFs. The prices of ETFs fluctuate with the value of their holdings. Investors can trade ETFs as frequently as they like.

How to select an ETF or Index Fund

1. Lower Tracking Error:- This is one of the important attribute for measuring performance of ETFs or index funds as against their benchmark. Tracking error is simply the difference in the returns between the ETF or index fund and its benchmark. Lower the tracking error, closer would be the returns of an ETF or index fund with that of its benchmark.

2. Low impact cost:-The impact cost is an indirect cost of executing a transaction on an exchange. Lower the impact cost, lesser the indirect cost to investors. Impact costs are lower where the liquidity is higher. To understand this, let us take an example. Assume you want to purchase 5,000 units of an ETF on the Bombay Stock Exchange (BSE), where the best-buy order of 1,000 ETF units is Rs.580 and best-sell order for 2,000 ETF units is at Rs.582. So, the ideal price is the average of the both, i.e. Rs.581. But if you were able to buy 5,000 units of that ETF at an average price of Rs.590, your impact cost is around one percent. This means that you incurred an indirect cost of 1 percent to buy 5,000 units of the ETF.

3.Low Expense Ratio:- The expense ratio is the annual charges of an ETF or index fund. It is the sum of fund expenses, management fees, administrative fees, operating costs and all other asset-based costs incurred by the fund. However, the expense ratio must not be looked at in isolation.

4. Historical Records and Liquidity:- It is very crucial to see the historical records of ETFs and index funds and liquidity in the case of ETF. Although historical records do not show future performance, these can give a rough idea as to how it has performed in the past.

Index Fund for whom?

Globally, the index funds are ruling the roost and have outperformed the actively managed funds. However, in India, these are yet to prove their mettle. In India, the actively managed funds and especially small-cap and mid-cap dedicated funds have managed to outperform the passively managed funds. The reason for this being lower efficiency of the capital markets in India. The asymmetric information availability helps a fund manager in India to create alpha for its investor. Nonetheless, they come with an added risk. We have witnessed how the NAVs of these funds have tumbled in the last few months. The fall in their NAV was more than the fall of their benchmarks.

Hence, if you are a risk-averse investor and volatility in the equity market disturbs you, index fund is a right prescription for you. The analysis of 381 equity funds, including index funds & ETFs, shows that index funds and ETFs exhibit lower volatility than the equity diversified funds. Moreover, they also give better risk-adjusted return, measured by the Sharpe ratio. The average Sharpe ratio for the index funds and ETFs come to around 0.61, as compared to 0.49 for the equity funds. Index funds give you predictable returns and you do not have to do continuous tracking. For example, if you wish to participate in equities, but do not wish to take the risks associated with actively-managed equity funds, you can choose a Sensex or Nifty index fund. These funds will give you returns matching the upside or downside of the index in which you have invested.

You should invest in them with long term horizon, especially if those index funds or ETFs are tracking some small-cap or mid-cap index. The reason being these can be very much volatile in the shorter run.

Why Passive Investment has not picked up

Despite all the benefits that an index fund offers, passive investing (that is investing in index funds and ETFs) are yet to catch the fancy of the mutual fund investors. The reason being passively managed funds are not able to generate attractive returns. According to a study done for all the actively managed mutual fund schemes from the period between FY96 and FY17, the returns generated by active funds have beaten the performance of the index funds by a huge margin. But during the bear phase of the market, the results are mixed as such funds have underperformed, while others outperformed. Hence, these funds lose more during the bear market phase.

Another reason why there are not many followers of passive investing in India is the lack of proper investment options. There are only 67 passively manged funds (including index funds and ETFs) and out of these 67 funds, 62 funds map their investment to the large-cap. There is only one fund that tracks mid-cap and three funds that track Nifty Bank.

Looking at the current scenario in India, where mid-cap and small-cap stocks are beating the performance of large-cap stocks by huge margin in the long run, investors might not be interested in parking their fund into a large-cap dedicated fund, even if it is low cost index fund or ETF. The mid-cap and small-cap dedicated funds still generate alpha for their investors and Indian investors do not have too many options. The reason why small-cap and mid-cap funds still generate alpha is that the space has more stocks to choose from, but the analyst coverage is significantly less and the institutional ownership is lower as compared to the large-caps.

The small-cap companies tend to be young and nimble with high growth potential. However, among the small-cap stocks, there is high degree of variability in quality, valuation and liquidity, which makes it hard to cast them in any index.

Therefore, even if a fund comes out with an index fund that maps small-cap index, it may not fully capture the small-cap stocks. Hence, domestically, we do not find much interest in the index funds or ETFs.

The Way Forward

Going ahead, we believe that the way the market regulator is moving and making regulations, creating alpha will be difficult for the fund managers. The host of changes implemented in the last one year such as re-categorisation of mutual funds, introduction of Total Return Index (TRI) as benchmark, disclosures on total expense ratio, etc. are most likely to move the market towards the passively manged funds.