Etf & Indexing - A Simple & Powerful Investment Tool

The Investment Puzzle

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The Investment Puzzle

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hivkumar Mahadevan picked up the files and books that covered his desk and neatly put them back in the little book shelf in the corner of his

cubicle. Then he switched off his PC and muttered under his breath, “Thank God it's Friday!” He loved his job as a copy writer in the advertising agency that he worked for but this had really been a busy week and he was looking forward to spending the weekend with his wife Mini and their five year old son, Aditya; especially now that they were expecting a little addition to the family. He had promised to take Mini shopping since she had already started getting a size larger and Aditya was continuously reminding him that he was keen to see the new children's blockbuster, which was running at a theatre close by. 7

The Investment Puzzle

ETFs AND INDEXING

"After twenty years of watching investment practitioners dance around the fire shaking their feathered sticks, I observe that far too many of their patients die and that the turnover of medicine men is rather high. There must be a better way. And there is! [index funds] - John C. Bogle, founder and retired CEO of The Vanguard Group

When he reached the lobby of the office,

Percentage returns from various forms of investment (1980-2005)

20

15

10

5

Prema, Vandana and Suhas were already there. Since they worked in the same office and lived in the same suburb, they

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had formed a car pool which included the four of them and Prema's husband Nilesh, who was

Source : RBI

Stock market

Fixed NSC deposits

PPF

Gold

a m a rket i n g m a n a g e r i n a n

It was then that Shiv actually felt a little worried. Although he had been working

investment firm around the corner.

for the past 10 years, he had invested very little of his savings in the stock market. He had a decent balance in a provident fund account and a couple of

As soon as they had settled down in the car, Prema turned to Shivkumar and chirped, “Hey Shiv, I heard that Mini is expecting a baby. That's great news. You must be really excited.” But before he could reply, Suhas cut in, “With all the additional expenses that you're going to have to meet, I think 'nervous' should

fixed deposits with various banks. A bulk of his savings had gone into paying for a house and a car that he had purchased when he married Mini 7 years ago. And in order to ensure that Aditya secured admission in a premium school, he had to pay a hefty deposit.

describe your state of mind better. I hate to be the one to burst your joy bubble but two kids means twice as much of everything. Have you started reviewing

He had heard that investing in stocks was the best way to build up wealth. In

your finances yet?” Shiv felt a little irritated at Suhas' attitude but he

fact, he had recently read in a leading financial magazine that in the long term,

remembered that Suhas was not called “Suhas the cynic” for nothing. He

the returns from equity-based investments far exceed the returns from any

always seemed to look at the worst case scenario of any situation.

other avenue of investment. At the same time he was aware that many investors had lost money in the stock market in the past. He knew enough

Nilesh, who had been silent so far, came to Shiv's rescue. “There's no reason for him to be worried. If he's been investing in stocks, Shiv could easily support

about the market to realise that such investors had lost money because they had tried to make a quick buck by investing on the basis of 'hot tips'. But then

twins or even triplets.” 8

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how could he be any different? Toggling between work and home, he had no “ The only way to "beat an index" is to invest in something other than the index. Why would you, when the only source of long-term risk and return data IS the index? Since you can't beat the index, be the index.” - Mark Hebner, Founder, Index Funds Advisors, Inc.

time to study stocks and track the market. While he was aware how Nifty, Sensex and other major indicators were moving, he could just not find the time or the inclination to go beyond. Then he realised with a wave of relief that Nilesh, being in the business of investments, was in a position to guide him. He admitted aloud, “To be frank, I have not invested in stocks.” “That's a shame,” replied Nilesh, “But why not?” Shiv explained that he had very little time and not much of an inclination to do a detailed study of stocks. “Since my job does not require it, I find it very difficult to acquire an in-depth knowledge of how the economy is moving and track various industries, much less sit down with annual reports and other stock

had already invested earlier at what seemed

specific reports and understand if a company has potential to deliver wealth in

like a peak. I really can't seem to figure it all

the future or not.”

out.”

Investing in stocks requires time and effort because it involves… Ÿ

“There's also the issue of keeping a track of

Ÿ Selecting the right stocks to invest in after studying a number of companies.

your investments,” she continued. “When I

Ÿ Timing the market so that you can invest when the market is climbing.

invest in fixed deposits and post office savings

Ÿ Following up on price trends once you have invested. Closely tracking

industries, the economy and corporate developments and their impact on equities. Ÿ Predicting the future

instruments, I can forget about them until I require the money or have to claim a tax deduction. But if I invest in stocks, I will have to be on the ball all the time. Even if I set out with the intention of investing for the long term, I must check from time to time that my investments do in fact

Vandana looked rather uncomfortable too, since she was in the same boat as Shiv. She was in her late twenties and was rather risk averse by nature. Although she had amassed a tidy sum of money since she began work, she had never dared to invest in stocks. “I haven't invested in stocks either. My main problem with this investment vehicle is that I can't bear the thought that one day my money is worth x and the next day it could be worth less. While I am ready to invest for the long term, I believe that to benefit from investing in

still have potential.” After hearing them out, Prema said kindly, “That's exactly the way I feel about stocks too. But why don't you invest in equity mutual funds*? Since you have professional managers investing your money in the stock market on your behalf, all you have to do is hand over your money and enjoy market linked returns. Over and above that, other advantageous features of mutual funds take care of all the issues regarding shares that we find so bothersome.”

stocks one must be able to time the markets. While I am aware how the markets are moving, I cannot gauge when they have peaked and when they have bottomed out. It would be such a disaster if I invest when the markets are close to their peak. At the same time, when the market keeps climbing, I wish I 10

*A mutual fund is simply an investment vehicle which pools together the resources of many individuals and institutions and invests this on their behalf according to a pre-stated objective. Each investor enjoys the gains from the invested pool in proportion to his contribution to the total fund. In case of losses, his capital is also eroded in the same proportion. A professional fund manager, with a team of market experts actively manages the investments in the common portfolio. Of course, a part of the fund goes towards paying the mutual fund manager and his team and meeting other expenses that arise in the wake of running the fund.

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The Investment Puzzle

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“Best of all,” she added, “mutual fund houses allow you to invest through Advantages of investing through mutual funds

SIPs…” “SIPs? What are those?” asked Shiv, glad to hear that he was not the only one who found the stock market confusing and keen to hear about the options that were available. “A Systematic Investment Plan (SIP) is a method of

1)Diversified portfolio A retail investor with a relatively small amount of money to invest cannot dream of diversifying his portfolio by investing in several companies. However, by investing the same small amount in a mutual fund, he can easily own a diversified portfolio, which in turn will mean a reduced level of risk. 2) Liquidity Mutual funds are of two types - open-ended funds and close-ended funds. Open-ended funds can be purchased from or sold to the mutual fund house at any time. Units of close-ended funds listed on the stock exchange can be bought/sold through a stock broker. Close-ended interval funds permit investors to redeem their units back to the mutual fund at stipulated periods. . 3) Tax benefits Various equity mutual fund schemes offer tax rebates to investors under the Income Tax Act, 1961. For instance, investments in Equity Linked Savings Schemes (ELSS), which invest predominantly in equities with a three year lock-in period offer tax benefits under section 80C. Moreover, dividend received from a mutual fund is exempt from tax in the hands of the unit-holder under section 10(35). A dividend distribution tax is, however, payable by a debt mutual fund under section 115-R before paying out dividends to its unit holders as per budget 2003 - 04.

investing regularly in mutual funds,” she explained. “When you invest through this method, you must invest a fixed sum of money in any mutual fund scheme of your choice on a regular basis, say monthly or quarterly or annually, just like a recurring deposit savings scheme with banks.” “With SIPs, you do not have to time the market. You simply invest predetermined amounts at predetermined intervals of time,” Nilesh clarified. He added, “In fact, the volatility in the market works to your advantage when you invest through SIPs. This is because when the NAV of a scheme is low, you purchase more units and when the NAV of a scheme rises, fewer units are purchased since you invest the same amount of money each time. Further, since you buy through bullish and bearish phases, your cost of purchase gets averaged out.” “It's a nice way to build up regular savings and inculcate a disciplined approach to investing,” Prema concluded. So far, Suhas the cynic had been quiet. Now it was his turn to tell Shiv what he thought. “By the way, did you know that there are 36 mutual fund houses in India at present with more planning to set up shop in our country? And were you aware that there are more than 1,800 schemes* available presently, with

4) Hassle-free investment The best part of a mutual fund investment is that once you invest, you do not have to manage the copious paperwork involved in churning a portfolio. You are also relatively free from spending time and effort researching the market and stocks. The asset management company will deal with all the necessary issues relating to investment, tracking and management of the equity portfolio. Your only job is to track the performance of your scheme.

varying investment objectives ? What I'm trying to tell you is that although the time and effort that you have to spend choosing a mutual fund scheme is less than what you may need to spend choosing the right stocks, it still entails a lot of work!” “You have to go about tracking the performance of schemes and keeping a

5) Regulated structure Mutual funds are regulated investment vehicles. They have to operate under strict guidelines laid down for investor protection. Implementation of the same is monitored by independent trustees and the regulator, SEBI.

watch on industries and market trends so that you are able to invest in the right type of schemes, i.e. those which suit your investment objective and risk appetite,” continued Suhas. “That's true,” said Prema sadly. Nilesh joined in saying, “What troubles me most about mutual funds is that since someone *Source :www.amfiindia.com

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else manages the entire fund, I feel like I have lost control of my money after

Shiv started to get that worried feeling all over again. He thought, “With the

investing. I have absolutely no control over the fund or fund manager.”

number of mutual funds increasing by the day, it will be difficult to choose the

Suhas, who seemed to be enjoying the fact that Nilesh was in agreement with him added vehemently, “There are empirical studies which show that most fund managers are no better at picking up stocks than the average retail investor. It is difficult for any individual to outperform the market consistently over the medium to long term. Just between us, if fund managers really

right one from among them. Keeping in mind the fact that it is difficult to outperform the market, is it really worth all the time and effort that I will have to invest in researching various schemes?” Then suddenly, he sighed and said out loud in exasperation, “I wish I could just invest in the Nifty and watch my money grow just the way the index does!”

manage money well - it's great, but if they cannot even keep up with a

“You most certainly can,” exclaimed Nilesh. “There are a number of mutual

benchmark index, then what's the sense of them earning fat salaries? It merely

funds that enable you to invest directly in the index. These are called 'index

eats into our investment as they get paid from the funds collected from

funds'.”

investors, anyway. In fact Daniel Kahneman, an economist who won the Nobel Prize in 2002, aptly said - Investors are just not going to beat the market. It's just not going to happen!”

“Are you serious?” asked Vandana half hopeful and half ready to see Nilesh smile mischievously. “Of course I am,” replied Nilesh. “Such funds invest their portfolios only in

Performance of actively managed equity funds vis-à-vis the Nifty Iindex* 1 Year^

are represented in the index. As a result, the performance of such funds mirrors the performance of the index.”

Average returns from equity funds$

-25.83%

9.69%

Performance of the Nifty

-21.75%

14.64%

Note: 3-year returns are annualized. $ Only Growth option considered. *The Nifty is an index which captures price movements of the top 50 stocks. It is a broad-based index, which helps judge the overall market movement. ^ As on 31st March 2008 Source: Mutual Funds India

Both Shiv and Vandana looked dejected. Then Vandana pointedly asked Nilesh, “Is it true that it is difficult for a fund manager to consistently beat the benchmark index of the scheme in the long run?” Nilesh replied, “Unfortunately, yes. It comes as a shock to most investors that a number of equity funds do not even match the performance of broader indices. The truth is that it is difficult to excel beyond the benchmark over the long run.”

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stocks that are part of a particular index, in the same proportion in which they

3 Year^

“Most investors, both institutional and individual, will find 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 and expenses) delivered by the great majority of investment professionals. ” - Warren Buffet, Berkshire Hathaway Chairman and legendary American investor

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ETFs AND INDEXING

The Investment Puzzle

“Wow! That sounds interesting!” said Vandana before Nilesh continued, “The mutual fund sector in India has a variety of such funds, so investing in the index is truly within your reach. In fact,” he added, “the mutual fund sector goes a step further to offer you funds that not only mirror an index but whose units can be traded on the stock exchange in much the same way as a common stock. These funds are called Exchange Traded Funds or just ETFs.” Before she could ask Nilesh any more about Index funds and ETFs, Vandana realised that they had reached home. She said goodbye to her co-passengers and got out of the car a little reluctantly, since she wanted to know more about these fascinating investment products. But she pacified herself with the thought that she could call Prema and Nilesh over to her place for lunch on the weekend and learn a little more about investing in indices.

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