Passive funds can make managers deliver better value: Tim Edwards, S&P Dow

"Historically, Indian investors have shown a very strong home bias - investing all or nearly all of their capital, domestically," says Edwards

Index-based investing is gaining currency in India. Tim Edwards, managing director, Index Investment Strategy, S&P Dow Jones, an index provider, discusses various trends around index management with Samie Modak. Edited excerpts:

Why are actively-managed funds finding it challenging to beat indices such as the Sensex?

In India, we observe the same shortfalls in active manager performance and unique local factors, which can be attributed to three sources: the typically higher cost of active management, increased professionalisation in equity market participants, and the skewness of stock returns.

Over the long term, it has historically been the case that a select few individual stocks have delivered returns much higher than all their peers. That might sound like an argument for active management but because those stocks are so far and few between, it is also an argument against concentrated stock picking. By participating in the whole market’s return, passive investors don’t run the risk of overlooking that small set of companies that will be future leaders.

Will there be more pressure on active managers to cut cost or deliver performance?

When a passive option becomes available, it can put pressure on active managers to deliver better value. Furthermore, since some investors have the option to take a passive approach, money is often taken away from the least-skilled, or unluckiest, active managers who have been underperforming, and invested in an index-tracker instead.

 

Do you think passive investment is the right tool to gain global equity exposure? Why have Indian investors largely shunned overseas investing?

Historically, Indian investors have shown a very strong home bias – investing all or nearly all of their capital, domestically. In particular, Indian investors have traditionally made few equity investments overseas. And for much of this century, Indian investors were rewarded with great performance from domestic equities. Understandably perhaps, financial advisors and asset managers have focused on first getting the home asset allocation right before foraying into global diversification.

But the Indian market is limited, missing world-beating representatives in areas of particularly high recent growth such as smartphones, internet search, biotechnology and many more.  This year showed the potential power of an international approach, and has changed perceptions on the potential merits of diversification in global markets.

It is said that a company enters the index when the best has played out. How do you see this?

While it’s true that a company needs great performance over time to be big enough to enter a benchmark, there are many, many companies that will never make it. If you knew which company was going to make the grade, then it will probably be a good investment. There is some evidence to suggest that – over the long term – smaller stocks generate higher average returns than larger stocks, albeit with higher levels of risk. But even then, the data is open to different interpretations. Over the past decade, larger stocks have generally outperformed in most major equity markets. In many cases, the investor may chose a balance of larger and smaller companies – both the established, higher-quality names of today, and the potentially more risky, but potentially higher-growth companies for the future.

Are there any peculiar challenges when it comes to index composition in India, compared to say, a market like the US?

Yes and no! On the one hand, the process of designing, calculating and disseminating benchmarks in India is similar to other markets. The S&P BSE Sensex, for example, is much the same today in terms of design as it was, nearly 40 years ago, when the index was launched. However, it is supported by a much deeper bench of infrastructure today. Nowadays, leading index providers like S&P DJI have to rely on a broad base of policies, procedures and production expertise that add a level of independence, accuracy and transparency to our indices.

There are important differences between different markets.  For example, there are many more and larger stocks in the US market, so quite granular exposures are possible to construct with diversified baskets – sub-industries, for example.  There may also be differences in terms of the level of fundamental and other data that can be used to build and maintain indices.

 

Where are you on the debate of capping index or a stock weight in an index?

If investors decide to award one company with a larger share of capitalisation than others, then market-based indices will naturally be reflective of that. Some indices include caps on the largest weights of single stocks or single sectors, or use other approaches to limit concentration. For each individual investor, or for some investment funds, the choice whether to follow a capitalisation-weighted benchmark or not is a matter of choice.

What are the further innovations that can happen in the index space in India?

India is in a nascent stage of passive investing, but the pace of innovation is warming up with increasing interest in passive exposures. While we cannot comment on specific products under development, there has been interest in a range of themes – including quite selective trends like companies focused in the innovation space, investments designed to reflect broader, non-financial characteristics like environmental or social objectives (ESG indices, for example), as well as so-called “smart beta” indices that encode active strategies in a systematic way. Even indices driven by artificial intelligence have been developed in other markets, and we could see these find an audience here too.