A quiet but powerful revolution has been unfolding in how ordinary Indians approach equity investing. Where earlier generations either left their savings entirely in fixed instruments or ventured into individual stock picking with limited research support, a growing number of investors today are embracing a simpler and statistically more reliable approach. This shift has been enabled by two realities: the INDEXBOM: SENSEX and the Nifty 50 together offer a well-diversified basket of India’s most significant companies, and low-cost index funds that track these benchmarks have made it easy and affordable to own a piece of this basket.
Why Most Active Funds Struggle to Beat the Benchmark Consistently
The case for passive investing rests on an uncomfortable truth for the fund management industry: most actively managed large-cap schemes in India have underperformed the benchmark index over extended periods of time given their higher expense ratios. It’s not a matter of the intelligence of the money managers, but a recognition of the challenge of outperforming a market which reflects the views of thousands of professional investors.
In India, as the market has matured and attracted more institutional participants, it has also become more informationally efficient – the information available about listed entities is absorbed quickly into the stock price, leaving less space for mispricing for active managers to exploit. The expense advantage of an index fund, which in the direct plan charges less than 0.2 per cent annually, has a greater impact when the alpha opportunities for active management get compressed.
This doesn’t mean active management has no role to play – in mid- and small-cap segments, where institutional research is lower and informational efficiency is lower, active managers have demonstrated a more consistent ability to outperform benchmarks. However, for the core holding in a long-term portfolio, and for retail investors who have neither the time nor the capability to rigorously sift through active managers, an index fund tracking a broad benchmark offers a compelling mix of diversification, low expense and ability to match market returns.
How SIP Investing in Index Funds compounds wealth
SIP investing in index funds is one of India’s most elegant financial innovations – combined with the diversification and low expense of passive management, it compounds wealth over long periods of time. Over 15-20 years, this has been demonstrated to vastly outperform inflation and create wealth.
The math of SIP investing in index funds rewards patience in a particularly potent way – as in any market correction (intrinsic to any long bull run), the fixed monthly instalment buys more index units at a lower price, while during market rallies it buys fewer units at a higher price. This creates a powerful tailwind as the unit price climbs on the back of rising earnings of the companies in the index, and the value of the SIP grows at an accelerated rate.
Factor Indices and evolution beyond simple cap-weighting
Beyond large-cap market-cap weighted indices, India’s index landscape includes options that track different factors – low volatility, quality, high momentum, value and combinations thereof. Exchange-traded funds that track these factor indices enable a more nuanced play on different segments of the market while retaining the benefits of passive investing.
Quality factor indices track stocks that have certain characteristics (like returns on equity, earnings stability, debt-to-equity ratio), and assign weights based on these characteristics. Such portfolios are less volatile and more resilient during market corrections, and appeal to investors looking to take a long term view on equities while minimising downside risk. Momentum indices track stocks that have delivered the best returns over a specific period (often six months) and are rotated out as soon as they stop outperforming.
Building a Core-Satellite Portfolio around index benchmarks
Financial planners are beginning to advise a core-satellite approach to portfolio construction in which most of the equity allocation (core) is in passive index funds, while a smaller portion (satellite) is in actively managed funds or individual stocks in which the investor has a conviction about outperformance potential.
This approach creates a reliable source of market-matching returns (core) while enabling the investor to take a view on specific opportunities (the satellite). However, this approach is predicated on the satellite allocation being within the capability of the investor – only those stocks/funds in which the investor has done due diligence and has conviction about should be considered. It’s a way for the investor to protect the integrity of the satellite portion, and avoid treading on speculation.
The expanding index product universe in India – spanning domestic and foreign equities, fixed income, gold, hybrid and so on – means it’s becoming easier to construct a truly diversified portfolio that meets the wealth creation goals of most investors without the need for constant active management and monitoring. For most retail investors, this is a welcome relief.
Key Points
- A significant shift in equity investing among ordinary Indians is marked by an increasing adoption of low-cost index funds that track the SENSEX and Nifty 50.
- Most actively managed large-cap schemes in India have consistently underperformed their benchmark indices due to higher expense ratios and market efficiency.
- SIP investing in index funds has shown to significantly outperform inflation and contribute to wealth creation over 15-20 years by leveraging the benefits of market corrections.
- The Indian index landscape now includes factor indices that allow investors to track stocks based on specific characteristics while maintaining the advantages of passive investing.
- Financial planners are recommending a core-satellite approach where a majority of an investor’s equity allocation is in passive index funds, supplemented by carefully chosen active funds or individual stocks.
- The growing variety of index products in India enables investors to create diversified portfolios that align with their wealth creation goals without the need for extensive active management.
