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B. Venkatesh

IN a recent survey conducted by the Journal of Indexes the respondents stated that indexing provides superior returns compared to active management. Many studies on this subject have also concluded as much. Why?

Take the S&P CNX Nifty. We will assume that this index is a fair representation of the market. Now, you have two kinds of portfolio managers — the index manager and the active manager. The index manager is one who simply invests in the index stocks in the same proportion. If Reliance carries 10 per cent weight in the Nifty, and if the index manager has Rs 100 crore, he will invest Rs 10 crore in Reliance (10 per cent of Rs 100 crore).

The active manager will invest in any stock that he believes will fetch good returns. Since there are many active managers, we can safely assume that the entire universe of active managers will invest in all stocks in the market. In that case, the universe of active managers will generate market returns. Since the index represents the market, this means that the universe of active managers will generate index returns.

Of course, some active managers will outperform the index, while some others will underperform. But we will not know beforehand (ex ante) who will beat the index. So, if you select the wrong manager, your returns will be lower than the index returns. Then, there is the high cost of investing — brokerage and impact cost — because of continual change in the portfolio. If we subtract these costs, the universe of active managers will likely under-perform the index. Such costs are lower for index funds, because these funds do not continually change their portfolio.

Due to these factors, index funds can arguably provide higher risk-adjusted returns. That is why some experts are strong supporters of index funds.

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