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Keep it Simple! Keep it Boring!Keep it Cheap!

An ETF is designed to do no better or worse than the benchmark it tracks. Passive investing is low cost and transparent.

Sanjiv Shah | Print Edition: December 14, 2006

Over the period of the last three months, one year and two years, Exchange Traded Funds have been among the best performing funds. Not surprising. In a letter written to shareholders of Berkshire Hathaway in 2004,

Warren Buffett wrote, “Index funds that are very lowcost are investor-friendly by definition and the best selection for most of those who wish to own equities.”

Buffett is a big fan of passive management. In another letter to shareholders, he said that ETFs have much in common with Berkshire. Both Berkshire and ETFs manage assets with integrity at low cost. Buffett is also said to have advised Bill Gates to put much of his non-Microsoft holdings into ETFs.

Question: What are the chances of finding fund managers who beat the index again and again? The answer is slim to none. Some active managers beat the benchmark for a year or two. But on the steep path of sustained excellence, almost all drop out.

A few funds have spanked the indices. However these often benchmark themselves against the wrong indices—for instance, amid-cap fund says it beat the Nifty. But index funds often win arm-wrestling contests even when they are not trying to outsmart anybody.

An index-fund manager comes to work knowing that the stocks he held yesterday are the same he’ll have today, tomorrow, next month and the month after.

In contrast, an active fund manager spends time analysing companies, dumping or acquiring stocks and deciphering the cryptic remarks of the finance minister, the RBI governor and corporate honchos.

Which leads to another question: Is passive investing the best bet? The answer is “Yes! Keep it boring. Keep it simple. Keep it cheap. Invest in ETFs.”

An ETF is designed to do no better or worse than the benchmark it tracks. Passive investing is low cost and transparent. It eliminates individual bias. And most importantly, it assumes that markets are efficient and all information discounted in price. It is about the science of investment rather than the art of investment. Now, it’s easy to index your way through all sorts of asset classes, including mid-cap stocks, sectors (Bank BeES) and bonds and in the future, commodities (Gold BeES) and international markets. If you prefer index funds with a bias toward a value or growth approach, in the future you will find those, too.

The complaint against ETFs is that they yield average returns. What is ironic is that investors who settle for average performance end up richer than cowboys who aim for “shoot-out-the-lights” returns. In the US, during the past decade, 82% of active large-cap funds lagged the S&P 500. Only 27% of small-cap funds beat their benchmarks and less than 14% of active midcap funds beat their respective indices.

Past performance means nothing when you try to guess—and it is just a guess—who will be rated the Decade’s Best Fund Manager in 2016. It’s better to stick with ETFs, a sure thing. The arguments are so compelling, more and more investors are bound to discover ETFs. So will the financial industry.

(The author is associated with Benchmark Mutual fund)

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