Pitfalls of passive equity investing

With the introduction of index-tracking mutual funds, there are now two ways to invest in the equity market. The first is the usual investment approach where the individual (or the fund manager) selects companies and sectors to invest in and continuously monitors those investments. This approach is called active investing. The second refers to blindly mimicking the composition of an index and aims to generate the index returns without attempting to outperform and at the same time avoid underperformance. This investing approach is called passive investing.

There are, however, certain pitfalls in the approach. The first is selection of an index to represent the “market”. There are many indices to choose from and this act of choosing an index to invest in is an act of active investing itself. There are some indices which are too narrow while some others may not be widely tracked. BSE Sensex which is widely tracked, for example, has only 30 stocks while some other indices such as S&P CNX 500 having 500 stocks is not widely tracked.

It is interesting to note that the criteria for inclusion in the index is the free float market capitalisation of a company and the liquidity and impact cost of its shares traded in the market. It is not an opinion on the business prospects or quality of the management. The index itself changes on a regular basis based on the recommendation of the index maintenance committee. An index fund is thus not free of churn and transaction costs. The savings in cost of an index fund over an actively managed fund would probably be around 0.5-0.7% per annum and it is not as high as it is sometimes made out to be.

Seth Klarman a renowned value investor asks us to do this thought experiment. He asks us to imagine a world where there are only index investors and no active investors are left. In such a world, he says that there will be no fund managers as there is no management of portfolios to be done. As a consequence, there will be no analysts tracking companies. We could do away with quarterly results and even publishing annual reports as there will be no one left to read them. The management of a company could pass any resolution, pay themselves any amount as salary, acquire and divest any company. They would not have to worry about adverse votes in a shareholder resolution or a slump in stock prices as everyone will just invest according to the index weights. Initial public offers (IPOs) will not get any funding as those stocks will not be part of an index. There will be no additional capital allocation to wealth creating companies and sectors and no withholding of capital from wealth destroying companies and sectors.

Meeting the criteria of getting into an index will be of paramount importance. Hence any company which can by hook or by crook, generate enough trading volume, liquidity and market capitalisation in its shares once for a period of a few months will have ensured a place in the index for a very long time and the promoters will have enriched themselves in the process. It will not be necessary for such a company to have a sound business model or even to commence business and demonstrate earnings. (If one looks at the history of the indices, there have been occasions where stocks recently listed got into indices like the Nifty. These stocks had huge trading volumes but the projects were still under implementation and there was no demonstrated earning power. Later events proved significant overpricing of many of these stocks.)

It is true that arithmetically a group as a whole cannot outperform itself. Hence all investors put together cannot outperform the indices. However, an active group which keeps company promoters and managers on tenterhooks and allocates capital efficiently can improve the performance of the index. The fees for active managers are not in that sense for beating the index but for them to improve the index return in itself. Ignoring the fundamental aspect of equity investing that is partnering in a business and turning it into a formula strikes at the very root of the concept of a joint stock company being subject to the oversight of its shareholders.

Rajeev Thakkar is chief executive officer and director, Parag Parikh Financial Advisory Services Ltd.

We welcome your comments at mintmoney@livemint.com