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Active investing will stage a comeback once index funds and ETFs become expensive

When many invest in index funds, the allocation to the underlying stocks increases and the prices can rise in a way that is disproportionate to their intrinsic worth

April 21, 2021 / 10:46 AM IST

There is an idea that is doing the rounds: if passive investing becomes pervasive, it will have major negative effects. One of the perceived negative effect is that people differ in their views on a stock, segment, industry etc. and allocate as per their convictions. Hence there is dynamism in the allocation to various stocks and segments. Passive investing, it is feared, will make the market monochromatic and apart from some index ETFs, will push out other products.

Let us examine aspect in detail.

Active to catch up with passive

The components of an Index are selected mostly based on market capitalisation, which itself is determined by how well stocks may be performing or their future potential. When many invest in index funds, the allocation to the underlying stocks increases and the prices can rise in a way that is disproportionate to their intrinsic worth – index funds must replicate the index and hence buy these stocks at elevated prices. Hence, this can crowd out other stocks, decrease market efficiencies and result in wrong allocation of capital.

But is that all? We need to delve deeper. If underlying stock prices of most equities that are a part of the index are high, the particular index itself will start underperforming relative to other equities/ indices. There will be equities outside of the index that may be attractive in comparison.


Stock pickers in the system will jump into the fray and invest in companies that are attractively priced and hence will be able to garner good returns.  Such performances will be noticed and a move away from Index / ETFs can be expected. Active stock picking and active fund investing will gain salience when index stocks/ Index funds/ ETFs become expensive.

Hence, the complete dominance of index funds/ETFs and absence of a strong counter party that takes contrarian calls will always be there in the market.

Institutional investors will buy attractive stocks

In the event equity markets do not allocate money suitably to companies that are intrinsically doing, large players such as hedge funds, private wealth, sovereign and retirement funds will spot such anomalies and step in to buy equities of such companies that are intrinsically good when markets are not valuing them correctly.

In fact, the more the money flowing into index funds, the higher is the potential for underperformance. Such a situation will make index funds less attractive. Actively managed funds will automatically fill the vacuum.

Then, there are hundreds of ETFs/Index funds (especially in the US where this worry is emanating from). Many indices are built around themes (Infrastructure, ESG etc.), sectors ( Bank, FMCG etc.) , strategies ( smart beta, inverse etc. ). Money is getting allocated to all kinds of ETFs/Index Funds that represent very diverse sections of the stock universe. It is never that only one kind of ETF will totally dominate. Hence, the diversity and dynamism would very much remain.

As regards India, actively managed funds are doing well in all categories, with the exception of large-cap schemes, in a relative sense. In this category, index funds are doing well as compared to most of the actively managed large-cap schemes.

Please note that even not accounting for Index funds, the selective allocation to a few companies that make up the top 30 or 50 companies is a major problem here in India. A set of just 5-7 companies have been driving the index valuations for several quarters. So, many actively managed large-cap funds in India did not do well whenever they did not buy the companies that were powering the index. Therefore, the problem of allocation to just a few companies is peculiar to India.

The next thing which we need to also appreciate is that the first 100 companies anyway account for 75 percent of the market cap. The skew is already there and pronounced in Indian market.

Now, even in Indian markets, there are many other indices apart from Sensex and Nifty. These include the Nifty next 50, Midcap 150, Small cap 250 and Nifty 500, where allocations are being made. These represent almost the entire market.

In India, there are other index funds and ETFs, apart from the ones above. Soon, we will also have thematic and sectoral ETFs that will are benchmarked against an appropriate index.

Smart beta indices and other flavours which are all passively managed have already started emerging.  Nifty 100 Low volatility 30 index or Nifty 100 Quality 30 are all new Smart beta indices against which ETFs are already there.

The diversity of indices and the multiple funds or ETFs that track them would mean allocation of money across the spectrum. This will ensure that a few companies or indices alone cannot always dominate. And allocation of capital cannot get skewed just because of passive funds coming to the fore, the way it is argued. The dynamism and efficiency of capital allocation will continue.

Finally, equity is one way of allocating capital. Debt markets, too, will open up for such intrinsically good companies, nullifying the bludgeoning effect of allocation to certain stocks only present in popular indices.
Suresh Sadagopan is Founder, Ladder7 Financial Advisories. He is the author of the book: If God was your Financial Planner
first published: Apr 21, 2021 10:46 am
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