How To Run An Index Fund
Whilst, therefore, the running of an index fund should be easy, why should anyone want to invest in such a fund? The reason is that it eliminates the risk related to the choice of shares. Every investor thinks he knows better than the market; every investor has his favourite shares, and shares he would not touch. But all such all-knowing investors make mistakes. In the finance ministry, I had a junior investigator, who did not even earn enough to support a wife. He had invested all his savings in obscure shares in the Harshad Mehta boom of 1992, and was wiped out in the subsequent bust. I met him recently and asked him if he had invested in shares again. He said, Yes, and I have lost again.
Poor young men can get as easily addicted to the stock market as to drink or crack. So can rich old men. But if they are still rich and old, they must have had more sense than to rely on unaided common sense: they would have studied the market and the companies, or engaged someone who did it for them. In western countries, many asset managers make a good living by investing money for people of high net worth. In this country such a profession is made impossible by laws of taxation and share registration. A growth fund is simply a standardised instrument created by an investment manager for investors who want maximum gains from shares.
Investment managers are expected to study, exercise judgment and be vigilant; and for that they are paid extremely well. The manager of Fidelity Magellan Fund, Americas most popular growth fund, gets more than $10 million a year. It is a good idea to choose a growth fund for its manager except that you never know when another fund will steal him, and you cannot keep jumping from fund to fund chasing your favourite manager.
Compared to managing a growth fund, management of an index fund is considered a mugs game; and investment managers of index funds are paid correspondingly little. They would be lucky to make $200,000 a year. The relative ease of management is also reflected in fees. Growth funds typically charge 1-1.5 per cent a year; in contrast, debt funds and investment funds charge about 0.5 per cent.
But running an index fund is not costless. An investment manager will have to be employed, he will have to have an office, a secretary, a stockbroker, an accountant, a car and a house. All these appurtenances have to be paid for. And the costs will go out of the funds gross earnings. So the fund will earn its unitholders less than if they invested directly. One would have to be extraordinarily rich to be able to invest in the shares which go into the Standard and Poor 500 in just the proportions in which they enter the index. But one would not have to do that: one could adequately track the index by investing in the top 10-20 shares. And then one would not be confined to a mindless strategy of tracking the index: if one occasionally saw a promising share, one could go overweight on it.
So why would anyone invest in an index fund? To begin with, because index funds do better than managed growth funds on the average. The S&P 500 has performed better than most managed funds in the past three years; in the last year it outperformed over three-quarters of managed funds. This is true of India as well: over the past five years, almost all growth funds have performed worse than the Sensex.
Even though managing an index fund requires no investment strategy, it is not without its skills. A mindlessly managed fund will do worse than an index for at least three reasons. First, there are the management costs, which must be deducted every year or every month from the net asset value of the fund. Next, payments into and out of a fund must be made in cash; the funds cash holding earn nothing, and its borrowings actually cost money. And finally, there are costs of investment and disinvestment.
An index fund managers skill lies in earning enough to offset the above costs, so that the fund closely reflects the course of the index. And those earnings come, to put it boldly, out of speculation. In the US an index fund manager is not confined to investing in the underlying shares. He also has the choice of buying or selling index futures. He will always be operating in the spot market for shares to keep his portfolio in balance; but he will also from time to time play the futures market. Thus when money flows into a fund, the manager will buy index futures for a future date when he expects to have realised the money and be ready for investment. Conversely, when money flows out he will sell index futures.
This type of speculation is more in the line of liquidity matching or hedging; but any decent manager will do more. He will choose the timing of his futures transactions; if he makes them at favourable prices he can expect to pick up some profit. In US markets as elsewhere, orders tend to flow into brokers offices in the morning. Then the brokers have to decide when to execute the orders; there is a general tendency to hang on and see if one can get a better price. Hence the volumes rise towards the close. That is when large deals are likely to enter the market, the prices can be volatile, and fortunes can be won or lost. This is as true of index futures as of individual shares.
Thus life need not be boring for an index fund manager; he can still play the market, and his skill and diligence will decide how well his fund tracks the index. The task should be a bit easier in India; the Sensex has only 30 shares in it, and the Nifty has 50. Constructing a balanced portfolio for these indexes should be much easier than to create one for the S&P 500. But to be efficiently manageable, index funds would have to have a certain minimum size: it is unlikely that they can be economical below Rs 50 crore. If Sebi ever approves an index fund, it should put in a condition that the sponsor would put in a corpus of the minimum size. It should also ensure that index futures come to be actively traded much before index funds are introduced. And finally, the government should ensure that provident fund and endowment insurance money is invested only in index funds, and not directly in shares. The PF and the LIC should not be speculating with money placed by savers with them for prudential reasons.