No case for passive investing in India for next decade as alpha lies outside indices: Vikas Khemani

Vikas Khemani, Founder, Carnelian Asset Management

Passive investing may struggle to deliver meaningful outperformance in the coming years, as India’s economic transformation is throwing up outsized alpha and wealth-creation opportunities outside benchmark indices, according to Vikas Khemani, founder of Carnelian Asset Management.

Speaking on the Zer01 Network's ‘Money Mindset’ podcast, Khemani said index investing in India is effectively a momentum strategy that captures stocks only after their strongest growth phase has passed. “Every time the economy transforms, there is a lot of opportunity to generate alpha outside the index,” he said, adding that India’s current phase of change offers a similar setup.

Drawing parallels with the US in the 1980s, Khemani cited legendary investor Peter Lynch, saying that he was able to outperform the index by about 14 percent by investing in companies that were not part of benchmark indices during periods of structural change.

India’s own liberalisation in the early 1990s presented a comparable opportunity set, he said. Banking and information technology -- two sectors that later became index heavyweights -- generated massive wealth while remaining outside the index. Axis Bank entered the benchmark only after its stock had already risen about 85 times, while Infosys joined after delivering 30-40 times returns, Khemani noted.

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“You come into the index once you do well. By then, you miss the biggest part of the opportunity,” he said.

Khemani also referred to a study conducted by his firm analysing changes in the Nifty over the past decade. According to the study, 25 stocks that were inducted into the index delivered an average compound annual growth rate of about 40 percent in the five years before inclusion, but only around 9 percent CAGR in the five years after entering the index.

Conversely, stocks that exited the index performed poorly while they were constituents, delivering negative returns of 7-8 percent in their last five years in the Nifty, but generated nearly 19.5 percent positive returns in the five years after being excluded.

“This clearly tells you that index investing is nothing but momentum investing,” Khemani said. With India seeing rapid change driven by new-age companies, manufacturing expansion and emerging business models that are yet to enter benchmark indices, he said the scope for alpha generation remains large. “There is no case for passive investing in India, at least for the next 10 years,” he added.

On the other hand, Pankaj Tibrewal, chief investment officer at Ikigai Asset Manager, said in the same conversation that only 30-40 percent stocks have been able to beat the index in the last few years, while 60-70 percent have underperformed the index.

The market breadth has deteriorated sharply over the past 15 months. During this consolidation phase, the median drawdown across market capitalisations has been deeper than the headline indices: most stocks have lost 15-20 percent even as benchmark indices are down about 8-9 percent from their peaks, he said.

With breadth worsening over the past 15 months, Tibrewal said the market is likely to remain firmly bottom-up, making stock selection and risk management far more critical than index exposure going forward.

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