The Fallacy of Passive Investing: Unveiling the Realities

Passively managed funds, such as index funds and exchange-traded funds (ETFs), have witnessed a surge in popularity, driven by the perception that they are less risky and that actively managed funds cannot beat the market.

The Self-Fulfilling Prophecy of Index Investing

The significant inflows into index funds have created a self-fulfilling prophecy where the rising demand drives up the indexes, attracting even more inflows. Experts points out that around Rs. 15,000 crore is pouring into the index every month, making it resilient even in the face of heavy selling by foreign institutional investors (FIIs). The substantial investments from sources like the employee provident fund organization (EPFO) have contributed to the continuous upward trajectory of the index.

The Danger of Excessive Index Creation

Experts raises concerns about the proliferation of numerous indexes, cautioning that the depth of underlying constituents (stocks) should be considered. If stocks are unable to handle the significant buying and selling volumes, distortions in the market can occur. He emphasizes that transparency is lacking regarding the criteria for adding or excluding stocks from the indexes. Undeserving stocks find their way into benchmarks, compelling passive fund managers to include them in their portfolios.

The Need for Regulating Index Makers

Experts calls for the regulation of index makers due to the growing significance of their role. He advocates for greater transparency, detailed methodology, and rationale behind index construction. Currently, the lack of clarity regarding the inclusion and exclusion of companies from indexes raises concerns about market-sensitive information and the potential impact on investors. Proper regulation and disclosure are necessary to maintain the integrity and quality of indexes.

Actively Managed Funds and the Long-Term Perspective

Experts challenges the prevailing belief that actively managed funds cannot outperform the market. He highlights the historical performance of various fund categories over a ten-year period, demonstrating that well-managed active funds have delivered substantial returns compared to index funds. Mutual funds offer a broader investment universe beyond large-cap stocks, and Experts emphasizes that indices are not designed to be long-term growth-oriented investment vehicles.

Fundamentals and Active Funds

Fundamentals play a crucial role in market performance, and active funds act as conscience keepers by pricing stocks based on their analysis. While passive funds follow the lead set by actively managed funds, Experts asserts that the prioritization and decision-making within the investment universe are driven by active managers. Therefore, active funds contribute significantly to overall market performance.

The Potential Risks

The continuous flow of money into passive funds poses risks to the market. Experts highlights the scenario where the EPFO withdraws a significant portion of its investments simultaneously with FIIs, leading to a potential market downturn reminiscent of the 2008 financial crisis. Moreover, Experts expresses concern about the misconception that index investing is less risky, emphasizing that indexes are inherently as risky as the equity market itself.

Conclusion

The rise of passive investing has brought forth new dynamics in the investment landscape. Experts highlights the risks associated with indexing, the need for transparency in index creation, and the consistent outperformance of well-managed active funds. Investors should be cautious in blindly adopting passive strategies and recognize the value that active fund management can offer in achieving long-term investment goals. Ultimately, a balanced approach that considers both passive and active investment strategies may yield optimal results.