Investment strategy: Benefit from the collective wisdom of markets

By going with ETFs, you eliminate decision-making, and emotional biases that come into play when picking active funds

The Covid-19 episode has given rise to uncertainty in all walks of life. While our work culture has already changed drastically, consumption patterns, too, are expected to see a massive shift. Earnings of both businesses and individuals are likely to be affected over the short to medium term. The resultant uncertainty has sent markets all over the world into a tailspin. The Indian equity markets have fallen by 38 per cent, with the benchmark Nifty 50 index going from a peak of around 12,300 to close to 7,500 within a matter of weeks.

Amid all the hysteria surrounding us today, it is easy for investors to fall prey to negative thoughts about the choices they have made until now. Witnessing the value of your portfolio built over several years erode in just a few weeks is not easy for anyone to digest. So, what should an investor do in such a situation?

The fall will not be permanent

It is almost impossible to predict accurately when and at what pace the global economy and markets will recover. However, the past can provide some guidance. Since 2008, which was the year of the Global Financial Crisis and subsequent economic recession, there have been only two instances where the returns from Nifty 50 (total return index) for a one-year period have been lower than 30 per cent at the lowest point in a calendar year. In the first instance, the annualised return over the next one-year, three-year and five-year periods from November 20, 2008, was 100 per cent, 26 per cent, and 21 per cent, respectively. The returns were on similar lines in the second instance too. This tells us is that over the medium to long term, the global economy and markets do bounce back, even after a major setback.

At the same time, investors need to adhere to some of the fundamental rules of investing. The most important among them is to follow an asset allocation that suits their risk appetite and goals. This varies from one individual to the other. Those who have not followed an asset allocation until now need to fix this issue right away.

Go with the right product

Equity is the asset class that has been proven to give higher returns over longer time periods and hence is suitable for long-term financial goals. But you need to select the right product for riding it. Should you go for direct equity investments or should you choose an actively-managed large-cap mutual fund? In our view, at this stage, neither of them would be the right choice. Both these options involve an element of arbitrary decision-making, based on some facts, but also based on some emotions and predictions. This makes future performance from them quite uncertain.

If uncertainty is a given, then why not rely on the collective wisdom of the entire universe of equity investors? This can be done by investing in the entire index, and that too in the same proportion. This intelligence of the broader market has, in fact, often outperformed actively-managed schemes. For instance, as on March 20 this year, the average large-cap category outperformed the Nifty 100 TRI by 1.5 percentage points over one year, but underperformed for three- and five-year periods, on an asset-weighted average scale. If we only look at the average of top five large-cap schemes, they all underperformed over the one-year, three-year and five-year periods.

Moreover, even the schemes that outperform the market are unable to do so consistently. For instance, a large-cap scheme that gave the highest one-year return in a specific year is unlikely to be the one giving the highest three-year annualised return in the same year. So even if you choose a scheme that has outperformed the market in the recent past, it is highly uncertain if that momentum will be sustained.

Invest in a broad basket of stocks

Now that we know that the collective wisdom of the market usually triumphs over actively-managed funds, there are two ways to passively invest in broad market indices. Either you can go for index funds, or you can choose index exchange-traded funds (ETFs).

Other than the fact that an index fund or an ETF is likely to outperform actively-managed schemes, they also offer an additional benefit. These passive investment options have a lower cost than actively managed schemes.

While both index funds and ETFs have their own set of advantages, one thing that clearly goes in favour of ETFs is their lower cost. The costs associated with investing in ETFs are lower than for index funds, which in turn are lower than for actively managed funds. Moreover, ETF units can be bought and sold anytime during market hours, thereby giving you additional flexibility to manage your liquidity.

Pay heed to tracking error

How should you select an ETF? You must first be certain about the index you want to invest in and if the investment suits your risk appetite and asset allocation. After that, you should select one based on expense ratio, tracking error and liquidity.

Remember that an index ETF does not aim to outperform the market; it merely attempts to mirror market performance. While doing so, there could be some tracking error. The lower the tracking error, the better it is for the investor. On the liquidity front, evaluate whether the ETF has good trading volume. This will allow you to buy or sell it as and when required.
 

An ETF spreads your investments across sectors while eliminating the emotional element from the investment process. ETFs have been gaining acceptance for some time now. As of February, the asset under management for all Nifty ETFs combined stood in excess of Rs 86,000 crore. Given the uncertainty prevailing in the markets at present, passive index investing is an idea you should embrace.

        Enjoy the ETF advantage

• In a climate of high fear and uncertainty, choosing the right stock or active funds can be difficult
• Going with an ETF eliminates the need to make these decisions
• While an active fund may beat an ETF over a certain time horizon, there is no guarantee it will do so consistently
• Expense ratios of several ETFs have plunged to just a few basis points
• If you select an ETF with good trading volumes, you will be able exit it easily during market hours 

The writer is executive director and chief executive officer, Nippon India Mutual Fund