Index Investing In India TNIA Talk Part 2

Summary

In this insightful talk, the speaker from Frean Cal discusses the nuances of passive investing, contrasting broad market indices with strategic or factor indices. They caution about concentration risks in broad indices and data mining in factor indices, highlighting the importance of understanding the risks involved. The speaker also addresses misconceptions about ETFs, emphasizing the significance of price-based metrics over NAV for investors. They conclude by recommending a predominantly large-cap portfolio with a possible addition of Nifty Next50 for those seeking moderate adventure, while warning against the pitfalls of assuming higher risk leads to higher returns.

Takeaways

• 📉 Active funds often underperform: The majority of active funds in various categories fail to consistently outperform their benchmarks, highlighting the appeal of passive investing.
• 📊 Types of indices: There are broad market indices like Nifty, Sensex, and strategic or factor indices, which combine elements of active and passive investing based on certain investment factors.
• 💼 Index investing methods: Investors can choose to invest in index mutual funds or ETFs, each with their own advantages and considerations.
• 🏦 Concentration risk in broad market indices: The top 10 stocks in indices like Nifty can dominate the weightage, leading to concentration risk.
• 📉 Risks of factor indices: While factor indices can show strong performance, they are also subject to underperformance periods and data mining risks.
• 🕒 Time lag in investment trends: Investment strategies that are popular in the West may take time to become popular in India, which can lead to adopting strategies that are past their peak performance.
• 📉 Beware of tracking error: The common practice of calculating ETF returns and tracking error based on NAV rather than market price can be misleading for investors.
• 💼 ETFs vs. Index Funds: While ETFs offer trading flexibility, they may not always provide better returns than traditional index funds, even with lower expense ratios.
• 🔄 Importance of price-based metrics: For ETFs, it's crucial to consider price-based returns and tracking differences rather than NAV-based metrics.
• 🌐 Liquidity and tracking concerns: In times of market stress, midcap and small-cap funds can face liquidity issues and tracking difficulties, making them riskier than large-cap focused funds.
• 📈 Nifty Next50 as a substitute: For those seeking exposure beyond the Nifty 50, the Nifty Next50 offers a good alternative with better liquidity and less risk compared to midcap indices.

Q & A

What is the main argument presented by P from Frean Cal in the first part of his talk?

The main argument is that most active funds, approximately 50 to 60% in every category, are unable to consistently outperform a representative benchmark, which supports the idea that passive investing makes a lot of sense.

What are the two types of indices mentioned in the script?

The two types of indices mentioned are broad market indices and strategic indices or factor indices, also known as smart beta indices.

How does the selection and weighting of stocks in broad market indices work?

In broad market indices, the selection of stocks and their weighting are primarily based on market capitalization. The free float market capitalization is used, which is the total shares multiplied by the market price, and adjusted by the investable weight factor (IWF) to account for shares that are freely available for trading.

What is the concentration risk associated with broad market indices?

The concentration risk in broad market indices refers to the issue where just the top 10 stocks can govern 50 to 60% of the weightage of the index, which means that a few stocks can have a significant impact on the performance of the entire index.

What are the two methods of index investing discussed in the script?

The two methods of index investing discussed are investing in index mutual funds and investing via Exchange Traded Funds (ETFs).

What is the difference between strategic indices and broad market indices in terms of stock selection and portfolio management?

Strategic indices combine elements of active and passive investing. They have specific rules for stock selection, and once selected, the portfolio of stocks is passively managed. In contrast, broad market indices are selected and weighted based solely on market capitalization without any specific thematic or factor-based rules.

What factors are used in strategic indices to select stocks?

Factors used in strategic indices include value, quality, low volatility, momentum, and alpha, among others. These factors are used to select stocks based on specific criteria, such as return on equity, debt-to-equity ratio, and other financial metrics.

What is the potential issue with factor indices that the speaker's friend warned him about?

The potential issue with factor indices is that they are subject to data mining risks. The speaker's friend cautioned that these indices may become popular in India after they have already been exploited in the West, leading to a time lag where the effectiveness of the indices may have already decreased.

What is the difference between ETF NAV and ETF price, and why is it important for investors to understand this?

ETF NAV (Net Asset Value) is the value of the underlying assets of the ETF, while the ETF price is the market price at which the ETF is bought and sold. It's important for investors to understand this because they transact at the market price, not the NAV, and there can be significant price-NAV differences that affect the actual returns and tracking error of the ETF.

What are the general risks in passive investing according to the script?

The general risks in passive investing include curation risk, where the rules for stock inclusion can change, concentration risk, arbitrary definition of factor indices, and the risk of fund managers changing the total expense ratio of passive funds to attract assets and then increasing fees.

What advice does the speaker give regarding the choice between ETFs and index funds?

The speaker advises to stay away from ETFs unless you are a trader, as they are not designed for long-term investing due to liquidity and price management issues. He suggests that for long-term investing, index funds may be more suitable, but cautions that lower total expense ratio (TEA) does not automatically mean higher returns.

What is the speaker's opinion on the choice between Nifty 50, Nifty Midcap 150, and Nifty Next 50?

The speaker recommends sticking predominantly to Nifty 50 for most investors. For those looking for a bit of adventure, he suggests a small allocation to Nifty Next 50 due to its liquidity and tracking ease compared to the Midcap 150, which he believes has liquidity issues and is more difficult to manage in a crisis.

What is the speaker's view on the relationship between risk and return in investing?

The speaker emphasizes that higher risk does not necessarily lead to higher returns. Instead, it leads to the potential for higher risk returns, which may or may not materialize. Therefore, a better risk management and asset allocation strategy is crucial.