PILOTLESS CARS INVESTING IN PASSIVE FUNDS

PILOTLESS CARS - INVESTING IN PASSIVE FUNDS

Satyajit watched with rapt attention as the unmanned Vikram Lander from Chandryaan-3 safely touched base on the moon's south pole. He had been listening to this impressive podcast on artificial intelligence-powered self-driving cars last week. He could guess that the future looks like sci-fi movies, where machines will rise to rule human emotion. Similar developments happened in the investment space, too, as passive strategies in managing money challenge the hegemony of active fund managers. Passive funds are designed to overcome human bias in money management, making them well-oiled machines that efficiently extract market returns with minimal human intervention and cost.

The oracle of Omaha, Warren Buffett, the world's most famous investor, felicitated an octogenarian at Berkshire's annual conference in 2017. The person was Mr. Jack Bogle, who launched the first passive fund in his company, Vanguard, in 1975. To appreciate Mr. Bogle's contribution to the rise of passives, let's dive deep into the difference between active and passive fund management strategies. For ages, active fund managers have been trying to beat the markets by investing in undervalued stocks, which they identify using fundamental or technical analysis. Fundamental stock picking is about understanding the macro environment, the sectors or industries that may perform well in the future and then selecting a company's stock within that sector. This typically is the top-down approach, where the manager leverages a deep understanding of the economy, sector and the typical company to make a long-term bet. Another method adopted is technical analysis, which is about following the trend and attempting to ride it for more gains in a shorter period.

On the other hand, passive funds accept the prevailing market price as the fair price. They buy and hold stocks replicating indexes like the Nifty 50 and S&P 500, regardless of their valuations or market conditions. Regulated service providers design indices and are responsible for regular upkeep and maintenance. They adopt specific rules of construction that identify the component companies based on size, market capitalisation, industry, or geographical location. The companies in an index fund are purchased and held when they meet specific index benchmarks and are knocked off when they move outside these parameters.

You may think of an index fund as an investment utilising pre-defined rules, just like the software running driverless cars like Waymo. Passive strategies are cheaper as they don't need fund managers to conduct costly research and drive them; the extra savings add to the return in the hands of the investors. The fintech distribution channels took these funds to the market and positioned them for DIY consumers, saying, ‘If you don’t know what to buy, buy the market.” Over the years, simple passive strategies have democratised the fund industry, attracting billions in investment. These strategies are also adopted by other asset classes, like bonds, gold, and real estate, with new fund offers regularly hitting the market.

Imagine being a driverless Waymo car passenger on an Indian road. You know the streets, but the danger is that you have no idea of the logic of how the car gets driven. It's scary indeed! Therefore, I am sharing a rounded view of the investment track on which the passive strategies run so that you can avoid any future surprises.

The stock market is a capital-allocating machine. A passive investor directs money only to yesterday's winner, thus missing the emerging players who could be tomorrow's champions. The indiscriminate shift into passive investment strategies involves throwing money into businesses based on their size rather than their prospects. The other interesting data point is that many index companies failed in the past. Unitech, Suzlon, Reliance Capital, Reliance Communication, Reliance Power, JP Associates, and DLF were all a part of the NIFTY 50 index a few years back. In rule-based index investing, an investor has taken exposure to these failed ventures. I have US-based research data that says 40 per cent of the US index companies are failures. But 7 per cent of the companies within the index did so well that they covered the losses incurred by the forty per cent of companies and delivered an overall profit. Companies are sometimes removed from the index because of declining economic prospects. These companies are typically replaced by companies from newer, vibrant industries that may positively impact the economy. The index evolves in a Darwinian mode, establishing survival for the fittest norm. Sometimes, therefore, a passive fund is more active, and companies are to be churned out to fit the rule-based index system, contributing to transaction costs.

The passive versus active debate is also a battleground for the Nobel laureates. The distinguished American economist Eugene Fama proposed the Efficient Market Hypothesis. Burton Malkiel extended his concept and compared portfolio managers with monkeys throwing darts in his famous book 'A Random Walk Down Wall Street'. Another Nobel laureate economist, Joseph Stiglitz, countered Fama's theory of the efficient market, stating that if market prices always reflect all information, data, news and trends, then no stakeholder will be incentivised to perform costly research-based trading, making the market inefficient.

Investing is an art with many shades of grey, and we need to adapt continuously to stay relevant. The choice between Active and Passive style is a classic ongoing debate about which scores over the other. After all, as Geoge Box said, "All models are wrong, but some are useful." Before concluding, I must return to the low-cost passive fund crusader Jack Bogle; his son chose a career as an active, high-fee fund manager, and the father invested some of his own money in his son's fund. As investors, we must have a balanced approach to both investment styles, complementing both the styles in the portfolio. We can sum it up in Lord Keynes's remarks: "When the facts change, I change my mind - what do you do, sir?"