Indexing is widely accepted to be one of the simplest and most effective approaches to investing. But, most investors are more aware of and inclined towards investing in actively managed mutual funds. Also the benefits and essential truths associated with indexing are not widely propagated and advertised. Therefore, making the shift from active to passive investing proves to be a process that is relatively harder. It therefore requires a significant degree of evolution on the part of an investor who prefers to invest in active mutual funds to be fully embrace index investing as an approach.
The evolution of any investor into an index investor happens in various stages. Each of us may be at a different point in the evolutionary process. And making the shift from investing in actively managed mutual funds to indexing proves to be the toughest and most counterintuitive stage of the process. But it is certain that any investor can complete the evolutionary process and embrace indexing wholeheartedly, provided they are willing to let go of their biases and put in the time and effort required. Therefore today I am going to talk about the various stages in the evolution of an investor and also show what it takes to make the transition from being an investor in active mutual funds to an index investor.
In order to be successful as investors, we must first have clarity on three aspects associated with a particular approach to investing. Firstly the philosophy, or the basic concepts and basis behind the approach. Secondly, a strategy which we would use to employ our chosen approach to investing in our investment portfolios. And finally discipline, which represents our ability to stick to our chosen approach regardless of external factors and pressures. Achieving a balance between these three aspects within a broader framework of simplicity as shown in the graphic that follows should be the central objective of our investing endeavours.
Most first time investors tend to buy investment products based on instinct and hearsay. They would also be highly unlikely to have knowledge with regard to concepts such as asset allocation and goal based investing. They therefore tend to end up with a highly cluttered portfolio containing a little exposure to almost every stock and/or mutual fund they may be aware of. And this does next to nothing for their portfolios and investment performance. Such a piecemeal approach to investing also clearly means that they create and build assets without a purpose. And this ultimately points towards a clear lack of philosophy, strategy and discipline.
Investors who are slightly more evolved would have a clear understanding of the concepts of asset allocation and goal based investing. Their investment approach is usually built around investing in individual securities and actively managed mutual funds, most commonly at monthly intervals. So these investors would quite clearly have a clear philosophy, strategy and discipline in place. The philosophy behind investment approaches centered around active management involves picking individual securities based on superior insight so as to achieve a higher than average return or even beat the return of a specified market benchmark.
But as shown comprehensively by the latest S&P Indices Vs Active (SPIVA) India report released in October 2022, most active management strategies fail to perform as advertised with any degree of consistency or reliability. I have discussed the findings of the report in detail in an earlier piece, Do We Have A Winner? Also, any investment strategy that is based on active management places focus on product selection. And this would require a lot of work to be done by the investor in terms of picking the right products for their needs.
It would also involve constantly reviewing the weights of various stocks in their portfolios and/or the portfolios of various mutual funds that they hold, not to mention the costs associated with potentially frequent churning of portfolios. Then there is the need for regular rebalancing. All of this would demand a lot of time, analysis and effort from us as investors. And the majority of us may not be able to do justice to the demands of such strategies. This may make cause us to constantly modify or change our strategies, meaning that we don't maintain discipline. And all of this points to the fact that the active management approach to investing lacks simplicity.
This leads some investors to realise that the complexity in terms of costs and the need for constant management that is associated with the use of active management strategies creates a performance gap which ultimately sees their portfolios underperform the market rather than outperform. They therefore realise that simply earning a return commensurate to a particular benchmark index over long periods of time while keeping costs and portfolio churn low may be the best option for them. And it is this realisation that helps them evolve and open their eyes to the benefits of index funds.
But waking up to the benefits of index investing and actually shifting the orientation of our portfolios towards index funds across asset classes are two very different ball games. Following index investing as an approach right from the beginning is fairly simple prospect. The real challenge would arise for those of us who have had a portfolio predominantly built of active funds until the present moment and now wish to switch approaches to index investing. In such a case, we must first be willing to make a permanent shift in our mindset.
We must shift from from analysing various mutual funds, looking at (largely useless) star ratings and expecting outperformance to appreciating that index investing is a simple, low cost and low maintenance approach that ensures that we are likely to have enough money to meet our goals over reasonable periods of time. We must also have the maturity to understand that having enough money for our goals and generating the highest returns on our portfolios don't necessarily need to go together. We must also realise that index funds do not offer downside protection.
In other words, if the benchmark index that our index fund tracks falls by say 15%, the equity component of our portfolios would also fall by 15%. Downside protection in such a case would therefore have to be achieved largely at the portfolio level by building a portfolio that is diversified across various asset classes. Finally, the asset allocation for our various goals and the frequency at which we wish to rebalance our portfolios must also be taken into consideration before we actually change the orientation and composition of our portfolios towards index funds.
The exercise of shifting the composition of our portfolios from active to index funds would begin with defining the number of funds we wish to hold in our portfolios. This may require us to redeem the lion's share of actively managed funds that we may currently hold and shift the proceeds into index funds. For all practical purposes large cap index funds would be largely enough for most of our long term financial goals. Those of us who wish to have exposure to mid caps in our portfolios may simply include some exposure to a Nifty Next 50 index fund, say to the extent of 50% of our equity portfolios for each long term goal. An aggressive hybrid fund that invests across market caps would be enough for small cap exposure.
The index investing approach can be applied to asset classes outside of equity as well. Although India currently lacks a pure and broad based index fund for long term bonds, a 10 year constant maturity gilt fund can be an ideal substitute. This is because such funds adopt a passive approach to investing in government bonds. They would therefore effectively serve as an index fund for 10 year government bonds. Those wishing to include gold in portfolios for their long term financial goals can look at gold ETFs. I have discussed this in greater detail in an earlier piece Low Cost, Highly Effective Portfolios.
All of this points toward the fact that becoming an index investor represents a move to an approach with a philosophy that is simple which can be converted into an easy to follow strategy. And this makes it easier for us to follow the strategy in a disciplined manner. And while it is becoming increasingly clear that the majority of actively managed mutual funds will struggle to outperform index funds and index fund like products going forward, it also takes a significant degree of maturity to be able to appreciate the approach of index investing in the right way and for the right reasons.
In other words, index investing should not be chosen solely on the basis that index funds are likely to perform better than actively managed mutual funds. As with any other approach to investing, index investing is not foolproof. There would be periods where index investing does not deliver results as expected. So becoming an index investor only for the promise of better returns may leave us disappointed. We must make the shift to index investing only when we find that it is a good fit in light of our asset allocation strategy, giving us the best chance of ending up with enough money for our goals regardless of returns. This would mark a holistic end to our transformation into genuine index investors.
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