Three emotional arguments against index funds that don’t make sense3 min read . Updated: 05 Nov 2020, 09:46 PM IST
Index funds provide a straightforward way to diversify and minimize investment cost
Rationality dictates that we use index funds instead of active mutual funds (MFs) in India. There are no robust rational arguments in favour of active MFs. Hence, beneficiaries of active MFs are forced to either use statistically incorrect arguments or emotional arguments. This article recaps the statistically incorrect arguments and refutes three emotional arguments.
Rationality leads to Index Funds
Over the years, I have written several articles about statistically incorrect arguments in favour of active MFs. This is an extremely brief summary. Free online MF databases do not show data for many active MFs that performed poorly and, hence, got merged into better performing active MFs of the same fund house. Hence, any analysis on such data is useless. The S&P Indices Versus Active funds (SPIVA) India report (bit.ly/2HWBQGS) is the only one that uses correct statistics. It shows that the average active MF does not beat the index. Further, publicly available research from S&P (bit.ly/360WXzH) shows that knowing which schemes outperformed during the previous five years will not help you select schemes that will outperform during the coming five years. Accordingly, no investment adviser can help you select active MFs that will outperform the index in the future.
And finally, with the benefit of hindsight, there will always be some active MFs that outperformed the index in the past. But that would be true even if active MFs were run by the random number generating function in Microsoft Excel spreadsheet software. This empirical data is exactly what finance theory also predicts.
emotional arguments against index funds
Let’s now look at three emotional arguments against index funds and in favour of active MFs.
Using your ego against you: Active MF mangers are often quoted saying that index funds (which charge 0.1% per annum) are for investors who are new to MFs while active MFs (which charge 1-2% per annum) are for sophisticated investors. This is intended to feed your ego if you use active MFs and deflate your ego if you use index funds. It also aims to hide the reality which is exactly the opposite. It is the investors new to MFs who select high-fee active MFs, while sophisticated investors use low-cost index funds.
The social proof argument: The social proof argument is that no one recommends index funds. And how can it be that everyone is wrong. Hence, it must be that active MFs are better than index funds. Let’s understand why almost no one recommends index funds.
Fund houses make significant profits on active MFs. And fund houses lose money on the Nifty 50 index fund (Direct Plan) which has fees of 0.1% per annum. Hence, any rational fund house would push the highly profitable active MFs and not push the loss-making Nifty 50 index funds. Further, the distributor commission of around 0.1% per annum on the Nifty 50 index fund (regular plan) is one-tenth of the 1% commission on many active funds (regular plans). Hence, any rational distributor will recommend active MFs and not index funds.
Finally, only a trivially small number of all other commentators about funds understand the SPIVA India report. This is primarily because it requires a deep understanding of statistics to correctly understand the SPIVA India report which is prepared over three months. Also, as Upton Sinclair said, “It is difficult to get a man to understand something, when his salary depends on his not understanding it."
The lottery ticket argument: This argument is that at your current rate of monthly savings and with low expected returns from all asset classes, you will not be able to retire when you would like to. And, hence, you require active MFs to try to get higher returns than the index. We already know that the average active MF does not provide higher returns than the index. So, this is really the same argument as saying that you will not be able to retire when you would like to and, hence, you have to buy lottery tickets to have some hope of retiring when you would like to. We all know that buying lottery tickets is not the solution to the retirement problem. The solution as I wrote earlier in Mint (read bit.ly/31Oy1KI) is to save at least half your post-tax income and to work at least in a lower stress roll till the age of 60.
In summary, as I wrote previously in Mint, “The golden rule of investing is diversify and minimize investment costs" and the straightforward way to do that is to use index funds such as the Nifty 50 index fund (direct plan). This may save 26% of your net worth and prevent you from destroying your spouse’s retirement.
Avinash Luthria is a Sebi-registered investment adviser and advice-only financial planner at Fiduciaries.in