The Investment Puzzle

SECTION 1

The
Investment
Puzzle

S 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
 ETFs AND INDEXING The Investment Puzzle

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

twenty years of watching
investment practitioners dance
around the fire shaking their feathered 20
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 15
better way. And there is! [index funds]
- John C. Bogle, founder and retired CEO
of The Vanguard Group
10

When he reached the lobby of the office, 5

Prema, Vandana and Suhas were already
there. Since they worked in the same office
0
and lived in the same suburb, they
had formed a car pool which
Stock Fixed NSC PPF Gold
included the four of them and market deposits
Source : RBI
Prema's husband Nilesh, who was
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
fixed deposits with various banks. A bulk of his savings had gone into paying for
chirped, “Hey Shiv, I heard that Mini is expecting a baby. That's great news. You
a house and a car that he had purchased when he married Mini 7 years ago.
must be really excited.” But before he could reply, Suhas cut in, “With all the
And in order to ensure that Aditya secured admission in a premium school, he
additional expenses that you're going to have to meet, I think 'nervous' should
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
about the market to realise that such investors had lost money because they
for him to be worried. If he's been investing in stocks, Shiv could easily support
had tried to make a quick buck by investing on the basis of 'hot tips'. But then
twins or even triplets.”

8 9
 ETFs AND INDEXING The Investment Puzzle

how could he be any different? Toggling between work and home, he had no
time to study stocks and track the market. While he was aware how Nifty, “ The only
way to "beat an index" is to
Sensex and other major indicators were moving, he could just not find the time invest in something other than the index.
or the inclination to go beyond. Why would you, when the only source of long-term
risk and return data IS the index? Since you can't
Then he realised with a wave of relief that Nilesh, being in the business of beat the index, be the index.”
investments, was in a position to guide him. He admitted aloud, “To be frank, I - Mark Hebner, Founder, Index Funds
have not invested in stocks.” “That's a shame,” replied Nilesh, “But why not?” Advisors, Inc.
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
Selecting the right stocks to invest in after studying a number of companies.
Ÿ your investments,” she continued. “When I
Timing the market so that you can invest when the market is climbing.
Ÿ invest in fixed deposits and post office savings
Following up on price trends once you have invested. Closely tracking
Ÿ
instruments, I can forget about them until I
industries, the economy and corporate developments and their impact on
equities. require the money or have to claim a tax deduction. But if I invest in stocks, I will
Ÿ Predicting the future 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 still have potential.”
Shiv. She was in her late twenties and was rather risk averse by nature.
After hearing them out, Prema said kindly, “That's exactly the way I feel about
Although she had amassed a tidy sum of money since she began work, she had
stocks too. But why don't you invest in equity mutual funds*? Since you have
never dared to invest in stocks. “I haven't invested in stocks either. My main
professional managers investing your money in the stock market on your
problem with this investment vehicle is that I can't bear the thought that one
behalf, all you have to do is hand over your money and enjoy market linked
day my money is worth x and the next day it could be worth less. While I am
returns. Over and above that, other advantageous features of mutual funds
ready to invest for the long term, I believe that to benefit from investing in
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 *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.
have bottomed out. It would be such a disaster if I invest when the markets are 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
close to their peak. At the same time, when the market keeps climbing, I wish I other expenses that arise in the wake of running the fund.

10 11
 ETFs AND INDEXING
Advantages of investing through mutual funds
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.
. purchased since you invest the same amount of money each time. Further,
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.
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.
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.
12
The Investment Puzzle
“Best of all,” she added, “mutual fund houses allow you to invest through
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
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
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
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
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
13
 ETFs AND INDEXING The Investment Puzzle

else manages the entire fund, I feel like I have lost control of my money after
investing. I have absolutely no control over the fund or fund manager.”
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
manage money well - it's great, but if they cannot even keep up with a
benchmark index, then what's the sense of them earning fat salaries? It merely
eats into our investment as they get paid from the funds collected from
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!”
Performance of actively managed equity funds vis-à-vis the Nifty Iindex*
1 Year^ 3 Year^
Average returns from equity funds$ -25.83% 9.69%
Performance of the Nifty -21.75% 14.64%
Shiv started to get that worried feeling all over again. He thought, “With the
number of mutual funds increasing by the day, it will be difficult to choose the
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!”
“You most certainly can,” exclaimed Nilesh. “There are a number of mutual
funds that enable you to invest directly in the index. These are called 'index
funds'.”
“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
stocks that are part of a particular index, in the same proportion in which they
are represented in the index. As a result, the performance of such funds
mirrors the performance of the index.”

Note: 3-year returns are annualized.

“Most
$ Only Growth option considered. investors, both
*The Nifty is an index which captures price movements of the top 50 stocks. It institutional and individual, will
is a broad-based index, which helps judge the overall market movement. find the best way to own common
^ As on 31st March 2008 stocks is through an index fund that
Source: Mutual Funds India
charges minimal fees. Those following
this path are sure to beat the net results
Both Shiv and Vandana looked dejected. Then Vandana pointedly asked (after fees and expenses)
delivered by the great majority
Nilesh, “Is it true that it is difficult for a fund manager to consistently beat the of investment professionals. ”
benchmark index of the scheme in the long run?” Nilesh replied, - Warren Buffet, Berkshire
“Unfortunately, yes. It comes as a shock to most investors that a number of Hathaway Chairman and
legendary American
equity funds do not even match the performance of broader indices. The truth
investor
is that it is difficult to excel beyond the benchmark over the long run.”

14 15
 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.

16 17