THE BEST INVESTMENT FOR A PASSIVE INVESTOR

The other day, I got a call from one of my golf buddies. He asked a very innocuous question, “I am having a lot of mutual funds in my portfolio, what should I do?” I gave a very simple reply, “Sell all of them and only buy a Nifty based Exchange Traded Fund (ETF). Buy every month a fixed amount on a rupee cost averaging method or a systemic investment plan(SIP) basis, till you retire. Do not look at the sensex or the TV. Just like a monthly PF subscription, buy every month and you will be rich.”

Like some of my other friends whom I advise, he was not convinced. He needed a lot of supporting research. Sometimes it amazes me that most of us believe an LIC or Mutual Fund agent who is very common in every Cantonment and buy sub optimal financial products on his advice rather than believe a friend who has the experience and financial qualification to give the correct input.

As per the classification of Benjamin Graham, the guru of Warren Buffett at Columbia,  armed forces personnel qualify as  ideal “passive defensive investors”.  The guy is comfortable with FDs, Real Estate, DSOPF and has not enough time and skills to do research and analysis. He wants wealth without working for it, nothing wrong in it, as all human beings do. For such an investor, the autopilot of an Indexed ETF is the best wealth creator.

Investing is all about common sense. Owning a diversified portfolio of stocks and holding it for the long term is a winner’s game. Trying to beat the stock market is theoretically a zero-sum game (for every winner, there must be a loser), but after the substantial costs of investing are deducted, it becomes a loser’s game. Common sense tells us—and history confirms—that the simplest and most efficient investment strategy is to buy and hold all of the nation’s publicly held businesses at very low cost. How can you own L&T, BHEL, Reliance, Hero Motors, Bajaj Auto, Maruti, HUL, P&G in your portfolio? Simple, you can own the best businesses of India by investing in an index based fund on a regular basis. The classic index fund that owns this market portfolio is the only investment that guarantees you with your fair share of stock market returns.

Out of the plethora of Index Funds, the best are ETFs due to their lower costs. And out of all the ETFs listed on Indian stock exchanges I like the QNifty and GS Nifty BEES, the best because of their least expense ratio and tracking error. Remember that an Index based ETF is not supposed to outperform the index. Just give you market returns. If the sensex has given a CAGR of 17.25% since inception, your ETF units would have also given similar returns had you invested in it. In simpler terms, if  Brigadier Bhakuni, another of my golf partners who has been a stock investor, had invested just Rs 1000/- per  month in an index based ETF since commission and continued till date (30 years) he would have  approx Rs 87,53,759/-.Not bad, Sir. Enough to discard, the Honda City and buy a Mercedes S Class with some loose change to spare. And the returns have been calculated on a conservative 16% CAGR on your recurring deposit. If you want to check the calculations yourself, go on any calculator site. One of the many calculators are listed below. Type amount of instalments per month as Rs 1000/- ; No of installments as 360 and rate of return as 16%.

 http://www.calcudora.com (though a US site I find it better than Indian sites)

John Bogle, the founder of the Vanguard Fund and creator of Index Based ETFs insists, in numerous media appearances and in writing, on the superiority of index funds over traditional actively-managed mutual funds. He believes that it is folly to attempt to pick actively managed mutual funds and expect their performance to beat a well-run index fund over a long period of time.

His arguments in favor of indexing are very persuasive. Plus, he presents historical return data to back up many of his points. He states that, in any given year, the S&P 500 index, in our case Nifty will often beat 80-90% of general equity funds. The index outperforms largely due to costs of equity funds.

While it is an established fact that the average mutual fund will never beat the index fund in the long term.  You might still get lucky and be able to find a particular fund which will consistently beat the index through superior research and stock picking. However, it turns out that there aren’t many funds that will actually outperform the index in the long run and it is exceptionally difficult to identify them. Several academic studies have attempted to identify persistently outperforming funds but they were unable to identify persistent winners. Past performance is definitely not a good predictor of future success.

So many times we have seen a good golfer hitting a birdie and then muffing his next tee shot. It is the phenomenon of reversion to the mean. The average handicap of the golfer will come into play. Similar is the case with investments. All investments also tend to give returns in line with their mean of returns over a long period. By reversion to the mean, we mean that if a particular asset class has better than usual performance for some period of time, it is likely to have worse than usual performance in the future to bring its average return in line with the historical averages. The stock markets never give a linear return. The returns are always non-linear. You may get zero or negative returns for a few years and then an explosive return of more than 100% in one year.

A  case in  point is  the difference in returns between value and growth stocks. There is enough data which shows periods of better performance for growth stocks and other periods where value stocks performed better. Your chances of selecting the top performing fund of the future on the basis of their returns in the  past are about as high as the odds that the Yeti will show up in pink pajama at your next cocktail party.

A study by Lipper Inc on US Stock markets has shown that over a 20 year plus time period there were only 37 funds out of 2423 funds which outperformed the S&P 500 index.

Warren Buffett wrote in 1996 in his annual report of Berkshire Hathaway, “Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees, salaries and expenses) delivered by a great majority of investment professionals.”

The only problem with this investment strategy is it is very boring. You will not be able to talk on the golf course or a barbecue party about how you own the top performing fund in the market. Secondly, it requires tremendous patience. 30 years is a long time. Even in DSOPF we like to withdraw when the corpus becomes large, a similar temptation may occur in this case too. So, if you have the will power and patience to tread this monotonous, staid, boring, unexciting, non-adrenaline pumping, low BP path of investing, then stop asking for any more advice and remove ET Now and CNBC TV18 from your cable TVs. Start from today, if not you, our inheritors and children are bound to get rich.

But if you still want to invest in stocks look at value. Noida Toll Bridge Co, Andhra Bank, Indraprastha Gas, GAIL, L&T for starters. Businesses selling at a price lesser than their values. Buy a rupee for eight annas.