Index funds: An Interview

What's an index fund?
An index fund is a mutual fund which merely invests in the securities in the index. It is passive, in the sense that absolutely no effort is made to produce results better than the index.
Why would that be optimal? Isn't it the job of the manager to try to outperform?
The reality of mutual fund performance is that most fund managers don't consistently outperform the index. In that case, it seems like a waste to pay their costs, and to incur the additional fluctuations in NAV that are introduced by their efforts. The index fund serenely moves along, it's NAV locked to the level of the index.

For a long time, the motto of many fund managers was "Don't just sit there, do something.". More recently, there was a cover story in Forbes about index funds which said "Don't just do something, sit there!".

Index funds haven't been around forever -- how did they come about?
Long ago, there was a student at the University of Chicago who studied modern ideas of finance taught by Eugene Fama and others. After graduating, he returned to his father's company (Samsonite) and was horrified at the active management being attempted by their pension fund. He telephoned his teachers at Chicago and asked for help, and they pointed him to a fledgling quantitative finance group coming up at Wells Fargo Bank. Thus was born the first index fund, with a modest sum of $6 million.
What index did they use?
At that time, the picture had not really clarified on indexes. They started off with a "equally weighted index", which shows the returns obtained by spreading the funds equally across all the components in the index. This turns out to be an extremely clumsy index for the purpose of index funds, because every time prices move, the index fund has to trade in order to rebalance the portfolio, back to equal weights.

It was some time later that the "market capitalisation weighted" index was connected up with index funds. This turned out to be perfect in the sense that when prices changed, market capitalisations changed proportionately. Hence a fund that was locked into the index portfolio yesterday "automatically" stayed on the index portfolio today, without any need for trading.

Internationally, how important are index funds?
In one way or the other, around one-third of professionally run portfolios in the US are index funds. There are stock market indexes of various kinds, bond index funds, industry indexes, indexes built of low P/B companies, etc. A variety of products can be created using these indexes. Leveraged index funds, index funds that promise to juice up returns using index arbitrage, index funds which "tilt" towards specified factors, etc., are all classes of products that can be created off a core family of good indexes.

Many actively managed funds are actually heavy users of indexation in disguise: they park 80% of their money in an index, and try to juice up their returns by doing active management on the remaining 20%.

Finally, all funds, whether they use index funds or not, are subjected to performance evaluation procedures that are based on indexes. In this sense, the indexation industry is truly pervasive.

It sounds like a pretty dumb affair: you just buy the index and sit on it. What's the catch?
Let's run through the process and we'll see the complexities.

At the start, suppose I give you Rs.500 crore and ask you to setup a Nifty index fund. It won't be easy to do that at a low impact cost -- most likely, you'll endup suffering a high trading cost in the actual implementation.

After that, anytime the index set changes, you have to sell off the companies that are deleted from the index and buy into companies that are added into the index. You pay impact cost.

Anytime a company pays a dividend, you have to go to the market and buy all fifty stocks in proportion. You pay impact cost.

Anytime a company does a rights or a GDR issue, it's market capitalisation goes up, so you have to sell all 49 stocks and increase your weight on this company. You pay impact cost.

Thus the real challenge of running an index fund lies in execution. The fund manager has to strive to make sure that the fund NAV closely tracks the reported index levels. This requires considerable skill in execution. It would be extremely embarassing to report to a customer that the index has risen by 10% but the index fund NAV has only risen by 9% (from the customers point of view, this could even be owing to fraud). The error between index returns and index fund returns is called tracking error. Different index fund managers compete on promising as low a tracking error as possible.

How does one get a low tracking error?
There are two lines of thought:
  1. By choosing an index which has as low an impact cost as possible. Nifty, and the other indexes that are in the works, are all unique (by world standards) in the way they are built out of a methodology that explicitly minimises the impact cost. You can't build a 50 company index with lower impact cost than Nifty.
  2. By being clever in the implementation strategy through which trading is done. One way to avoid owning stocks altogether in implementing an index fund is to just get index returns using index futures only. This is called a "synthetic index fund" and is the most common strategy (worldwide) through which index funds are implemented.
Why is all this so important? Or, what's so compelling about index funds that they should account for one-third of professionally managed funds in the US?
There are really three issues why indexation is so crucial:
  1. The reason mentioned above, which is that active managers haven't been able to perform too well. Hence, passive management is the natural alternative.
  2. Suppose one does want to do active management. For a large fund, it is pointless to take small positions in a few stocks based on stock picking -- this can't affect the fund NAV appreciably. And, if the fund attempts to buy large quantities of what it thinks are undervalued stocks, then the impact cost faced upon purchase generally wipes out the extra returns that are derived from the underpricing.

    Hence the way forward for active management is to shift focus away from individual stocks to entire sectors of stocks. Suppose you think that the cement industry is undervalued, then buy the entire cement industry index. You could easily invest Rs.5 to Rs.10 crore at under 1% impact cost on buying the entire cement industry index over a few days. Such large positions are infeasible on individual stocks at low impact costs.

    Many kinds of sectors of stocks could be used for such active management: industry indexes, a low P/E index, bond market index, etc. Active managers of the future will work by juggling their proportions of these sectors, instead of devoting effort on identifying individual stocks which are undervalued -- that is more of a retail activity better suited for people with very small funds to invest.

  3. Finally, index funds have thrived because of situations where a committee invests on behalf of a constituency. An example of this is a provident fund committee which is investing the PF money on behalf of all employees.

    It is extremely embarassing for the PF committee to pick an active manager who then turns out to underperform. It is much easier for the PF committee to face their constituency and say "we just picked an index fund, and the overall index went down, hence our fund value dropped".

What's the status of indexation in India?
In India, Nifty is the first index which is really well-suited for index funds and index derivatives. UTI and SBC Warburg are currently working on doing an offshore index fund on Nifty. Some other index funds based on Nifty are in the pipeline. NSE plans to soon have index derivatives based on Nifty.

Index funds and derivatives on the same index have a powerful synergy: the existence of index derivatives enables index fund managers to reduce the tracking error, and the order flow from index funds helps improve liquidity on the index derivatives market.

Going beyond Nifty, a midcap index (Nifty Jr.) using the same methodology as Nifty is under development. When it is launched, it could also be used for products. The combined portfolio, formed of combining Nifty and Nifty Jr., could also be used for products.

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