Craze for index funds distorting market dynamics; passive investing no free lunch: Dhirendra Kumar

Dhirendra Kumar, Chief Executive Officer, Value Research

A lot of money has been flowing into passively managed funds such as index funds and exchange-traded funds over the last year. To a large extent, this approach is being driven by the popular perception that a) index investing is less risky and b) actively managed funds don’t beat the market anyway. Both views are wrong, says Dhirendra Kumar, Chief Executive Officer, Value Research. Index is as risky as the market, and well-managed active funds have beaten benchmarks by a wide margin in the long run, he said in an interview with Moneycontrol.

Kumar said massive inflows into index funds were creating a kind of self-fulfilling prophecy where the inflows are driving the indexes higher, which in turn is attracting more inflows.

“You now have around Rs 15,000 crore pouring into the index every month, so the damn thing won’t go down even if FIIs sell heavily,” he said. Kumar also flagged the creation of a large number of indexes as a dangerous trend.

“That really won’t make a difference because you will finally have to see what is the depth of the underlying constituents (stocks). And if the stocks are unable to absorb the huge buying and selling, it will create distortion,” he said, adding that there was not much transparency about how a stock was added or excluded from the indices. Also, a lot of undeserving stocks were becoming part of the benchmarks, leaving passive fund managers with no choice but to buy them.

“Index makers need to be regulated because the business is becoming serious. They need to put the methodology out there in great detail, and give the rationale for whatever methodology they have,” Kumar said.

Edited excerpts from the interview:

What are your thoughts on the craze for passively managed funds we are seeing currently?

Till a few years back, I had this feeling that indexing will be a non-starter for a long time. The reasons were obvious. We are an emerging economy, the market is very broad and very shallow. It will always be under-researched, less known. The premium for knowing things or value added by a fund manager will only be seen in the non-index universe. If you see, over the last many years, most mutual fund investors have made their money in multi cap funds, flexicap funds, large cap funds. Indexing is like a self-fulfilling prophecy. Till you have more money coming into an index fund, you will not have an index that will be able to make a case for itself. Once money starts coming in, the index starts moving up, which in turn attracts more money. That is what you are seeing in America, and now that is what you are seeing happening in our index as well.

So, what has changed?

You now have around Rs 15,000 crore pouring into the index every month, so the damn thing won’t go down even if FIIs sell heavily. All the EPFO (employee provident fund organization) money is going into index funds. Today, the size of EPFO assets in index funds alone is roughly Rs 3.2 lakh crore. About 5-6 years ago, the total equity assets of the mutual fund industry were around Rs 2.5 lakh crore.

Today the investment universe is around 3000 stocks, but institutional investors own less than 800 of them. Despite increasing disclosures and better rules, India still remains a shallow market, and that is why I felt that actively managed funds should do better.

Is the huge inflow into passive funds a good thing or a bad thing?

Defeating or matching the index is not an investing goal. Remember, indices are not created with the purpose of being an investment vehicle, least of all a long-term growth-oriented one. Indices are created to be a sensitive barometer for the day-to-day gyrations of the equity markets. So, they are not fit to do the secondary duty of being your investment portfolio. That is why you will often find some undeserving names in the indices. If you notice, the best active fund managers will never buy all the stocks that are part of an index, and even if they do, they will not be in the same weightage as the index.

So EPFO has been the game changer?

It is the best avenue that they have. If they get into finding an active fund manager and allocating money, that will be a non-starter. If something goes wrong, it will be subject to all kinds of vigilance inquiry. I am not a purist. If you can’t do the perfect thing, do the next best thing.

So money will keep pouring in…

Yes, it will keep coming in.

And the index will keep rising

Yes, it can

What do you think about the creation of many indices?

That really won’t make a difference because you will finally have to see what is the depth of the underlying constituents (stocks). And if the stocks are unable to absorb the huge buying and selling, it will create distortion. Today, roughly 60 companies make up seventy percent of the market capitalization, around 200 companies account for the next 20 percent, and around 1,800 companies make up the bottom 10 percent.

If you notice, in the last three years, FIIs were selling, but the market did not go down. And when FIIs started buying, the market just can’t stop going up.

So then the answer is to create more indices, no?

There is an issue. The Junior Nifty is the next 50 stocks after the Nifty, from 51-100. And a single buy or sell order of Rs 50 crore could push some of the stocks in this index to the upper or lower circuit filter. When we conducted some stress tests for some investors, we found that we were able to sell all the stocks, except two, which hit the lower circuit. The issue is that when a stock hits the circuit, the index calculation stops.

What are the perils of too much money flowing into passive funds?

Investing should be an objective thing. It should be a function of earnings, quality, demand-supply. But if demand gets distorted, and the other factors remain the same, that is a problem, because demand-supply is an important variable.

But in India, like in the rest of the world, the trend is clearly in favour of passive investing?

Yes, but the numbers are creating a misleading impression that index investing has finally arrived. Today, there is greater awareness among newcomers to the market, it’s fashionable to be knowledgeable about the market thanks to various sources of data and information. You hear about youngsters saying I put my money in index funds because active funds don’t anyway beat the market. That is not really true. Because mutual fund investments are done for the long term, not for three or five years.

Looking at the numbers, over the last 10 years, large cap funds have delivered an average return of 13.61 percent, large and midcaps 16.6 percent, flexicap 15.36, midcap 19.58, small cap 21.57, value-oriented 16. Assuming the whole large cap is index, then it has been beaten by all other categories today. 16.6 compared to 13.6 over a 10-year period is not a small margin.

The point you are making is that over longer periods, actively managed funds have been delivered.

Exactly. And for another reason. Mutual funds is not all about large caps. Much of the money goes into other categories. And for other categories, we don’t have benchmarks. So there are no index funds (for those categories). And if there are indexes, they are fake indexes.

But we have a lot of indexes out there.

They don’t have the depth, they don’t have the thought. Earlier we had only two indexes for many years. Then one day SEBI came up with the idea that mutual funds managing money should beat the index. And since there were different kinds of funds, there should be different indices. So everybody got into a huddle for creating all kinds of indexes. For index makers, it was quick money to be made, because funds using the indexes have to pay license fees for using the indexes. The result was that all kinds of funny indexes were made, without any thought to whether they would work, or whether they were replicable. And that meant trouble for the fund houses. Because the index may have stock, but the fund cannot run it like that.

And the S&P (global) has a mechanism whereby they have two indexes: one the same name-one for fund managers and the other that acts as a barometer (sentiment indicator). India does not have that. Index makers could not care less. They put the numbers on an excel spreadsheet, collect their money, and end of story. And they need to be regulated because the business is becoming serious. They need to put the methodology out there in great detail, and give the rationale for whatever methodology they have.

Isn’t that already out there in the public domain?

I haven’t found what is the mechanism for including companies or ejecting them. Being excluded because of corporate action is one thing. It has to be transparent and clear. Because now it is market-sensitive information.

Are transparency and depth the only problems with the indexes?

Quality is completely out of the dimension of selection. So we have all kinds of companies creeping into the indexes.

Is this a risk that the index believers are ignoring?

It could be a problem for some, and an opportunity for those who are not index believers. Finally, fundamentals will prevail. If companies don’t make money, index won’t keep going up. This will not be noticed in good times, but in bad times, they will definitely be a drag on the index.

Regulators too seem to favour passive funds, looking at the proposed light regulations for them to ease the compliance burden.

Managing passive funds is easy, it requires less regulatory supervision, you don’t really need to bother about front running. You don’t need to worry about the liquidity of the underlying funds. So they are easy to regulate. That is one reason. But regulators can’t make anything happen. Consumers have to like it. Investors will like index funds only if over a long time they are making more money than others. The EPFO money will continue to flow in no matter what, because that is the only avenue available to them. And I don’t see a success in non-EPFO money.

But fund houses are launching ETFs by the dozen. So clearly there is demand for passive products?

Yes, but it is only the Sensex and Nifty funds that are getting meaningful money. In many of the ETF funds based on recently formed indices, the assets under management are in double digits, and in some cases even single digits. And the expense ratio (fee that the funds charge) is very low. So the fund houses won’t even make money on them.

Then why are so many funds being launched?

There is a technical factor here. SEBI came up with a fund classification rule; it defined categories such as large cap, mid cap, multicap and said that no fund house can have more than one fund in each category. But there were no restrictions on launching index funds and ETFs. So if somebody creates an index and you want to launch a fund based on that index, you are most welcome.

Passive funds don’t make much money. Some fund managers say it is the active funds that are subsidising passive funds.

It is better to make something than nothing. It is fine till they make some money. Fund houses don’t make money on liquid funds, but they have been running them, no?. They are launching funds in the hope that someday even a small fee on a huge asset base will be decent enough. It is a land-grabbing mindset.

If money keeps flowing into passive funds, how will fundamentals ever be relevant?

In theory, the game should go on forever as people keep buying even the stupid stocks. But so far, it has not happened that way. Reason is that even if quarter of the money is in actively managed funds, that money sets the pricing. Passive funds have to follow that. Look at the HDFC Bank and HDFC stocks, they have not gone up in the last two-and-a-half years despite being part of the major indexes. Within the universe there is a prioritisation, there is something set outside of the index.

So actively managed funds are the conscience keepers of the market?

That is right. And that action (by active funds) will translate into market performance.

What could break the virtuous cycle of passive flows taking indexes higher and in the process attracting more money?

The day EPFO decides to pull out a large chunk of money. And god forbid if that happens to be at the same time FIIs also want to take some money out. In such a scenario we may witness a 2008-like scenario when markets went down by 60 percent in 7 months. My bigger problem is the well-meaning, but naïve people who go around preaching that index is less risky. Index is just as risky as the equity market.