Simon Karaban, Director, Research and Design, S&P Dow Jones Indices, fields a few questions on index versus active investing.
Indian indices tend to tilt towards a few sectors and stocks. The Nifty has a 28 per cent weight in financial stocks. The top five stocks account for a 35 per cent weight in it. Do investors mimicking these indices run concentration risks?
The S&P CNX Nifty has been designed to provide an efficient representation of the broader Indian stock market. However, one single index should not be seen as the solution for all investors’ needs and requirements.
If an investor is fearful of the degree of concentration in one index, he can supplement his investment in the index with exposure to other funds, stocks and ETFs to achieve a desired outcome.
Those in favour of index investing often argue that a majority of active funds don’t outperform the indices. But as long as there are a fair number of funds outperforming, isn’t there a good enough case for active investing?
Indeed, there is a case for investing in active funds. But how many investors are capable of picking the winner on a consistent basis?
The S&P Indices Persistence Scorecard in the US shows that active funds that have performed well in the past have difficulty repeating that performance in the future.
In fact, according to the Persistence Scorecard published in June 2012, less than one per cent of funds that began as a top-quartile performer in March 2008 ended up in the top quartile almost four years later.
Investing directly in stocks and index funds investments are complementary in nature. Investors may use the index fund for their core exposure to a given market, and then supplement that core exposure with direct investments in stocks to suit their risk profile.
Over ten years, the top five diversified equity funds have generated returns of 22-26 per cent per annum against the 19.6 per cent from the Goldman Sachs Nifty ETF. Is this not a good enough incentive to invest in active funds?
Past performance alone should not dictate an investment decision.
Investors taking on active risk should also consider a wide range of factors when assessing the ability of the fund to deliver good returns on a consistent basis — and this exercise alone may be too expensive and time consuming for some of them.
For investors looking to buy or sell ETFs through the exchange, the differential between market prices of ETF units and NAVs is quite high. The absolute return on the GS Nifty BEES over five years is 20 per cent. But the total return on the Nifty is 25 per cent…
Typically, ETFs that are more widely accepted and heavily traded will have narrower spreads and trade closer to NAV.
In the example offered, much of the deviation between the ETF and Index is due to the management fee. The annualised tracking error for this fund is only at 0.12 per cent.
Index funds in India often have high tracking errors. Fund managers say this is on account of frequent index changes and high impact costs. What is your view on this?
As an index provider, we always do our best to make our indices easy to replicate; however it is up to the ETF providers to make sure that there are no tracking errors.
Broad market-capitalisation weighted indices will generally have low turnover and the index committee usually try to limit the frequency of changes within the indices.
The S&P CNX Nifty, for instance, includes in its methodology high liquidity criteria thus reducing the turnover.
It is set so that the index may also be used as an underlying for derivative instruments, such as futures and options.
Investing directly in stocks and index funds investments are complementary in nature. SIMON KARABAN, DIRECTOR, RESEARCH AND DESIGN, S&P DOW JONES INDICES