In the following blog I have attempted to answer and address some common misconceptions as well as misplaced beliefs about indexing...some of these may be of more relevance to Indian investors.
Myth-1: The index is typically comprised of a smaller number of stocks whereas the fund manager or stock picker can pick and choose from the entire market.
Reality-1: The number of stocks, in an index is not relevant, what is important is how much or what percentage of market capitalization the index captures or maps.
Therefore indexes when used as (cash market) investment vehicles in index funds or ETFs try to capture the various sources of risk so that investors can hope to earn the resultant expected returns.
Hence, for example, a total market index is designed to mimic the behaviour of the market as a whole and thereby capture its characteristics and peculiarities i.e. equities as an asset class.
Similarly other indices such as large-cap or mid-cap indices or narrower sector indices-help capture the behaviour and peculiarities of the respective sub-segments of the market or sub-asset categories.
An individual stock (or even a handful) cannot hope to capture a market’s behaviour nor the characteristics of any of its sub-segments-and this also true for portfolios managed by individual managers / advisors.
In other words individual stocks (and managed portfolios) will have a wide range of outcomes or returns (at random)-relative to the market.
Myth-2: A cap-weighted index generally tends to ‘overweight’ large and growth companies and ‘underweight’ smaller and / or ‘value’ ones.
Reality-2: Nothing really is known about ‘fair value’ of a security and therefore any stock (regardless of its capitalization) is just as likely to be ‘over or undervalued.’
In other words the presumption that large-caps are overvalued is rather ‘subjective’ and a result of individual opinion...therefore it can never be the ‘absolute’ opinion.
Further, due to the beauty of the cap-weighted ranking method-if the price of a big company falls for some reason-its aggregate market cap will also fall-and as a result the security will reduce in weight and ‘rebalance’ automatically / instantly in the portfolio.
E.g. some big banks in US indices fell in ranking in the broad market indices (due to fall in price) as the sub-prime problem broke out-and they automatically moved (rebalanced) to a lower slot as (simultaneously) other companies from different sectors moved up in weighting.
In the cap-weighted index-all these adjustments happen instantly and automatically as events unfold.
On the other hand-in actively managed portfolios the investor or portfolio manager has to take a view i.e. remove some of those companies or instead buy more? In an actively managed portfolio one has to decide whether to increase the weight or reduce the weight of individual components-as events unfold rapidly.
Myth-3: Fund management experts are better placed (relative to the market) in arriving at ‘correct valuations’ or right price of a security-and therefore indexing is on a weaker ground because there is no expert taking calls on valuations.
Reality-3: What is the definition of right price? It is the ‘price’ at which a ‘buyer and seller’ enter into a voluntary exchange of goods and services! This happens all the time in a free market.
This makes the ‘market price’ as closest to the fair value of a security because numerous buyers & sellers are entering into voluntary exchanges-based on their choices and perceptions.
The market price of a security is the best estimate of what numerous market participants (all those buyers and sellers including numerous professional managers / analysts) are thinking at any given point in time.
Some individuals (typically active investors) can keep arguing about the definition of ‘right price’ because each of them has a subjective valuation process-to use an analogy e.g. different buyers of an apartment will (each) have different criteria for arriving at the right price or valuation of the same apartment.
Some will dispute with the price or ‘value’ of the apartment (for a number of reasons) saying it is ‘overpriced’ while several others will define the ‘price’ as ‘right’ because of proximity to school, or railway station or overlooking a garden and so on.
The right price is therefore the agreed price between the apartment buyer and seller. When both enter voluntarily into a transaction-it becomes the market price or fair price.
An analyst can spend days and days (working on a spreadsheet) making arguments why the ‘agreed price’ of the apartment was incorrect...but value finally lies on the eye of the beholder and no amount of expert analysis (done independent of the market process) can change this reality.
‘Market Price’ of a security aggregates dispersed knowledge of numerous market participants.
Hence when an individual active investor is attempting to ‘beat’ or ‘outguess’ that price (through commonly known tools / methods of analysis in active investing) it is the equivalent of playing ‘chess’ against thousands of invisible opponents.
Myth-4: Companies or stocks (usually) get into an index after the run up happens hence those stocks are already overpriced-by the time find a berth into an index.
Reality-4: The presumption over here is that there exists some authority (an individual expert) who knew the right valuation (of the stock) in the first place.
But for a moment let us assume that some active investors did manage to spot some great companies in their infancy i.e. before they got into the index and hence managed to capture a good deal of returns in infancy. However, those smart active investors also ended with some lousy stock picks-this happens all the time!
Let us assume that the lousy picks (the negative outcomes) were a case of ‘bad luck’...it would then imply that the great picks (done in infancy before those stocks got into the index) were ‘good luck.’ Some financial economists would call stock picking outcomes as the equivalent of throwing darts-mostly luck!
In a highly competitive and efficient market it implies that the ‘absolute skills’ of individual portfolio managers is intact...but their skills relative to the market are on the decline.
The market is nothing but an entity comprised of numerous equally brilliant active managers / stock pickers-all trying to outperform each other and by that definition- the market.
Myth-5: Index components are decided (periodically) by the index committee-hence there is a stock selection process involved-similar to active management.
Reality-5: There is a major difference: the index committee is not paid to beat the market. In direct contrast the objective of an active manager is to outperform the relevant market (index) and the manager is paid to do so.
Therefore the criteria of an index committee are to formulate a portfolio that is at best a representative sample of the characteristics and behaviour of a market and by definition this should map the market (or its sub-segments) in terms of value or capitalization.
Moreover, once security ABC or XYZ gets into an index-its subsequent change in fortunes (i.e. Its weight in the index) are left to the market forces. The index committee goes out of the picture.
On the other hand the same security in an actively managed portfolio will be regularly monitored by the portfolio manager who will take (active) decisions based on various criteria-such as profits, brand, competitiveness, ROCE, new projects, change in management, FII positions and so on and so forth, fund inflows and outflows into his scheme, trading calls, his own insights, gut, market information and so on.
Myth-6: Outperformance in the ‘efficient’ US market maybe difficult-agreed! However, in emerging markets (like India) experts can (as yet) locate mispricing with relative ease and hence consistently beat the market (index)
Reality-6: First of all let us understand-the composition of the modern Indian stock market- we have numerous MF managers, FII managers, hedge fund managers, PMS managers, insurance companies, treasury managers-bank and corporate, pension managers, analysts, family offices, broker-advisors and many other professional active managers-all of whom are attempting to beat the market and are paid to do so. Financial media adds to the information flow in the market.
Therefore publicly available information in a competitive market like India-is essentially ‘broadband’ or a commodity.
This competition results in efficiency.
In other words-alphas is a reality in any efficient market-but they are random, transient and known in hindsight. Therefore there are no ‘free-lunches’ or proverbial diamonds (mispricing) lying scattered on a heavily populated road just waiting for the fortunate few to pick them up! Even if ‘mispricing’ anomalies exist-they are kind of randomly scattered and it is rather tedious to capitalize on them consistently.
One can outperform only by exploiting the mistakes of others-but in a market that is increasingly dominated by professionals-it is difficult (for individual managers) to locate victims i.e. consistently.
Even if the market is presumed to be ‘informationally’ inefficient-for every alpha in the zero-sum game (of outperformance) there will be an ‘anti-alpha’ or underperformance. Hence for every out performing manager or active investor there will be an underperforming counterpart somewhere in the system.
Points to Remember:
A cap-weighted index portfolio is a representation of the entire market (or its segments) and therefore at any given point in time the index is a reflection of the way the world (investors in the aggregate) values its assets.
Any active deviation from market weights-is an individual judgement and no subjective valuation (done independent of the market process) can ever be sacrosanct.
Therefore any active deviation from market weights can lead to out and under performances-which will be random, transient and known in hindsight.
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