Index ETFs should be the core portfolio of investors: Here's why
Posted by: Uma Shashikant on Jun 25, 2018, 06.30 AM IST
By Uma Shashikant
General Electric has just dropped out of the Dow Jones Industrial Average. It was one of the 12 stocks to be included in the index when it was created over 120 years ago, and the last one to get out. Changes to an index represent changing times and hold some important lessons about blue chips.
An index is a representation of the market. It is well established that tracking a few actively traded stocks is a fairly good indicator of the overall direction of the market. Indices are a parsimonious and efficient way to track the market. Some argue that every stock in the market should be included and tracked. Laborious efforts have been made, including by RBI and CMIE, to create broad-based indices. However, the correlation between these indices and the narrow ones like the 30-stock Sensex or the 50-stock Nifty, is very high. It is not worth tracking too many stocks to track the market.
A narrow index of 12, 30 0r 50 stocks tracks large and highly traded stocks listed in a market. It thus represents the blue chips or market leaders that are established businesses from various sectors. It is a diversified portfolio of top stocks. The index thus becomes a benchmark for forming risk and return expectations from investing in equity. Investors can simply buy the index at low cost using exchange traded funds (ETFs) that enable such investment strategies to earn market returns.
Returns from equity investing are also measured using the index. These results documented across many markets around the globe show the story of how equity returns beat inflation, bond yields and other investment opportunities over a long period of time. consider buying and holding equity stocks for the long run based on such results.
The story of the index and replicable superior returns are both made possible not by buying and holding a chosen blue chip stock for the long run. It is primarily enabled by holding a portfolio of diverse stocks and by revisions that throw out what is not working and bring in new stocks that represent the current trends in business success. Therefore, there is no case for buying and holding without review.
Reviewing the names in our own Sensex will show how things change all the time and how favourites get edged out of the index. In 1986, when the index was released (and also back calculated to April 1979) it included blue chips of those times: Century Textiles, Mukund Iron and Steel, GSFC, Hindustan Motors and Scindia Shipping, to name a few.
All these stocks were blue chips at that time. They were large, well established successful businesses and were actively traded. However, with changes in the economy, business conditions, competitive environment or management within the company, these blue chips fell into bad times and faded off.
The story of blue chips is also about there being no formula for businesses to succeed. With the benefit of hindsight, we may be able to thread together practices that enable a business to excel. But none of these insights are adequate to define a successful business ahead of its actual stellar performance. And none of these metrics persist to keep the business at the top forever. Businesses that have featured in the books of management gurus who searched for excellence or listed business that were built to last or went from good to great, have all failed spectacularly. Some businesses last and continue to lead the sectors they are in. Hindalco, Mahindra and Mahindra, L&T, Grasim and Tata Motors have been in the index for the longest time. But they have also gone through their trial and struggle as times changed, and modified their business strategies for the new world as they saw it.
The question for investors is whether they would have been able to isolate the handful of businesses that stood the test of time, from the ones that failed along the way, if they were shown the 30 or 50 names when these indices were built. Each one in that list was good enough at that time. To imagine that one could have picked the best, and left out the rest is unrealistic. Perhaps loads of luck would have to aid that decision.
To replicate the index is a better approach than trying to pick a few bluechip stocks and hold on to them for the long run. The business risks and management risks will persist, and the investor may lose out on newer businesses that hold better promise. Investors choosing from the Sensex stocks in 1986 and shutting themselves out to whatever came later, would have missed holding Infosys, HDFC Bank, TCS, Airtel, and Maruti Auto for example—stocks that rose to become blue chips much later.
The best shot at long-run returns from equity comes not from individual stocks held for the long-term, but from holding a diversified portfolio that is reviewed to weed out what is not working and include stocks that hold potential. This is done objectively by an index committee that works with defined parameters for inclusion and exclusion. With an ETF, it is possible to hold the index and benefit from this reviewed portfolio for the long term.
Active fund managers strive to do better than the index, by modifying the weights to the index stocks they hold—they overweight or underweight stocks based on their views. They also hold non-index large caps to take a shot at better returns. These large-cap funds also offer an opportunity to hold a diversified portfolio that benefits from review. Just as one cannot tell which stock will outperform in the future, one cannot tell which fund will do better than the index much in advance. Stock selection and fund selection, both are subject to risks of choosing and holding losers rather than winners. Winners don’t persist in both cases, either.
Index ETFs that protect from selection risks, held for the long run without any effort at review or revision, and at a low cost, should be the core portfolio of an investor. To this core, a set of equity funds can be added to include the benefits of stock selection and
review by a manager. This satellite portfolio will have to be reviewed and revised annually. Beta returns from the index, and alpha from fund managers is a combination that should work for most investors.
The author is Chairperson, Centre For Investment Education and Learning
(Disclaimer: The opinions expressed in this column ..