We started this newsletter to promote the virtues of low-cost index funds. One of our goals was also to publish diverse views from advisors who use index funds to implement client portfolios. We reached out to Avinash and he graciously accepted to write on Indexheads. This is a first post in what we hope will be a long series of articles by advisors, practitioners, and other smart folk from the industry.
By Avinash Luthria
Avinash Luthria is Founder, SEBI Registered Investment Adviser (RIA) & Fee-Only (Advice-Only) Financial Planner at Fiduciaries; He was previously a Private Equity & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore; He writes about Financial Planning & Investing in Business Standard, Mint, MoneyControl, The Ken, FreeFinCal, VCCircle etc; Views expressed here are of the author and do not necessarily reflect the views of the Indexheads newsletter.
Second-order thinking explains why you should invest in index funds and also the most suitable index fund products
All your domestic MF investment should be in index funds and index-like funds with fees of less than 0.20% p.a.
The delusion of alpha leads to paying high fees to MF managers and Distributors / SEBI RIAs who will help you select the right MF managers. This leads to wasting roughly 1% of your net worth each year. When cumulated for over 30 years, you will lose 26% of your net worth. Mental math shows that you will lose close to 30% of your net worth. And any calculator will provide the exact number which is that you will lose 26% of your net worth.
I have written articles which explain that the average Indian active mutual fund does not beat the index; an article which explains the S&P Indices Versus Active Funds India report which proves this; and an article which provides a layman intuition for why it is so hard to beat the index. This article begins with the more fundamental problem that all of us judge what is correct or wrong based on intuition. But our intuition often fails us on several complex topics including about why index funds make sense.
First-order thinking is superficial while second-order thinking is deeper - both of which I describe later. That is why second-order thinking explains a lot of counterintuitive effects. It requires second-order thinking to understand why the average active investor is, net of costs, guaranteed to underperform the index. Similarly, it requires second-order thinking to select suitable index fund products in a developing country like India which does not have easy access to obvious ideal products such as the Vanguard Total World Stock ETF, or even the Vanguard US S&P 500 ETF. Since the products available in India are far from ideal, the set of bearable products is counterintuitive.
Part 1: Second order thinking explains why you should invest in index funds
The average active investor is (a) before costs, guaranteed to match the performance of the index and (b) net of costs, guaranteed to underperform the index
An easy example
First-order thinking may go something like this: “Let’s pass a law to limit the rent on properties so that they become more affordable to a large number of tenants”.
Second-order thinking on the same topic may go something like this: “If we pass such a law, then firstly, owners of properties might refuse to invest in the maintenance of their properties and hence tenants will be forced to stay in bad properties. So, we will also have to pass a law to force property owners to maintain their properties. Second, some property owners may decide not to rent out their properties and may prefer to keep them vacant. So, we will have to pass another law to penalize owners who keep properties vacant. And finally, potential buyers of properties will realize that they cannot get an attractive rent on properties so they will stop buying properties. So, we will have to budget for the government to buy properties and to rent them out. So, it is difficult to say what the net outcome of all of this will be i.e. eventually it is possible that both property owners and (future) tenants suffer.”
On such simple topics, ideally one should be capable of original second-order thinking. But on certain topics, we may not have the ability to. In those cases, we should aim to understand second-order thinking where someone else did the original thinking.
Two slightly more complex examples
First-order thinking leads one to think that communism (central planning by a few intelligent people etc) ought to work very well. Second-order thinking results in the counterintuitive realization that capitalism (the wisdom of the market) works better than communism.
Similarly, first-order thinking leads to the instinct that it is not possible for the human brain and consciousness to have emerged from chimpanzees or worse still, a single cell organism. Second-order thinking helps to understand how evolution (the marketplace where genes indirectly compete) can explain the emergence of the human mind, consciousness and (the approximation of) free-will. Try explaining this to yourself in a few simple sentences. If you are in the 1% of people who can, you will get a glimpse of how instinct fails most people in such complex topics. If you are in the 99+% of people who are unable to, it will illustrate that just because you are not able to understand and explain evolution, that does not make evolution wrong.
In both these cases, none of us understand these topics well enough to have come up with this second-order thinking ourselves. But we could try to study it and understand it. There is no guarantee that we will succeed in understanding it, but we can try.
Second-order thinking applied to active investors and index funds
First-order thinking (i.e. superficial thinking) leads to the intuitive conclusion that the average mutual fund manager should be able to beat the index (which is the wisdom of the market). Second-order thinking (i.e. deeper thinking) leads to a counterintuitive and opposite conclusion. Nobel prize winner William Sharpe proved mathematically that the average active investor is (a) before costs, guaranteed to match the performance of the index and (b) net of costs, guaranteed to underperform the index. None of us are capable of ourselves coming up with William Sharpe’s brilliant proof in two pages with no equations in ‘The Arithmetic of Active Management.’ But we could try to read it and understand it.
Further, promoters (dominant shareholders who are also managers) of companies have the most amount of information about their companies. So, they are likely to be above-average active investors in their companies. Hence, it is difficult for the average MF to be an above-average active investor. Almost all individual investors who think they are directly or indirectly (via a MF) above average active investors are delusional.
We find it easier to spot delusions where only a minority of people believe it (e.g. Communism, superstitions and disbelief in evolution). And we find it more difficult to spot delusions that a majority of people believe in (even if I limit myself to current international examples, they would be politically incorrect to list here). So, you have to work harder to overcome a delusion that a majority of your peers believe in.
Nobel prize winner Daniel Kahneman uses the term System 1 to explain our quick, useful, and intuitive way of thinking to deal with things that we are familiar with. And System 2 is the deliberate and slow thinking approach that each of us have to deal with new situations. Ideally, when we face a new situation, System 1 should hand over to System 2 to think it through carefully. But when faced with a new situation, System 1 sometimes makes a mistake and deludes itself into thinking that it knows how to deal with this. Like the question of evolution vs. disbelief in it and communism vs. capitalism, the question of active funds vs. index funds is too complex for System 1. It is a job that requires you to trigger your System 2, study it and think deeply about it till your head hurts.
26+% of your net worth is at stake and that ought to make it worth the hard work.
Part 2: Second order thinking identifies which index fund products you should select
Indian individual investors should invest in index funds and index-like funds targeted at institutional investors and corporate investors with fees of less than 0.20% p.a.
Almost all insurance investment products are pathetic. So, compared to that, almost all mutual funds are infinitely better. But if one ignores that irrelevant comparison, then mutual funds targeted at individual investors are unattractive. Take the permanent example of, mutual funds launching multiple useless and expensive schemes (sector-specific funds/thematic funds/contra funds/focused funds). This uses a loophole in SEBI’s regulations to create multiple schemes with low assets under management (AUM) per scheme and this allows mutual funds to maximize the fees that they charge individual investors. Or the mutual fund which used hundreds of crores of investor’s funds to bail out the overpriced and failing IPO of a sister concern. Or the mutual fund which recently tripled its fees on one direct plan debt mutual fund scheme from 0.23% p.a. to 0.70% p.a. The list of such examples is endless. And this situation is likely to stay this way for decades to come.
On the other hand, mutual funds targeted at institutional and corporate investors are very good. Luckily for individual investors, SEBI’s regulations force mutual funds to offer the same products at the same fees to all investors. Hence, Indian individual investors are in the unique position of being able to access the same products and at the same fees as institutional and corporate investors (Note: There is one minor exception, but it is not important). And institutional and corporate investors won’t tolerate such shenanigans by mutual funds. So, in such products, mutual funds know that if they gouge investors, then they will lose the large investments from institutional and corporate investors. So, the best way for individual investors to avoid being gouged is to invest in products that are targeted at institutional and corporate investors.
Hence, ignore mutual funds products that are targeted at individual investors and invest in products that are targeted at institutional and corporate investors. These are index funds and index-like funds which have fees of less than 0.20% p.a.
The relevant Equity mutual funds are Nippon India Nifty 50 Index Fund (or Nippon India Nifty 50 ETF), UTI Nifty 50 Index Fund, HDFC Nifty 50 Index Fund and ICICI Nifty 50 Index Fund. The fees are 0.05% to 0.10% p.a.
The relevant debt mutual funds that take almost zero credit-risk are Quantum Liquid Fund (NOT Quant Liquid Fund), Parag Parikh Liquid Fund, Motilal Oswal Liquid Fund and the category of Overnight Funds e.g. SBI Overnight Fund, Franklin India Overnight Fund. The fees are 0.10% to 0.20% p.a. (Note: People find it difficult to understand the category of Overnight Funds and that is why I have suggested these zero credit-risk Liquid Funds where you can study the portfolio and understand them).
Naturally, all investments should be in ‘Direct Plan-Growth Option’ (this is automatically true for the ETF).
A few of the design principles that have been used here are:
The debt MFs mentioned here take almost zero credit risk. If you are unhappy with the low expected returns of these debt mutual funds, then your primary option is to evaluate whether or not you can handle the significant risk of higher equity allocation. Note that it’s possible that equity does not beat these debt mutual funds even over a period of 20-30 years (‘Why it’s a myth to say that equity is safe in the long term — Often, people take too much risk believing the myth that equity is safe in the long term’).
My aim is simplicity. That is why I have not synthetically constructed a Nifty 100 index. A Nifty 100 fund adds very little extra diversification compared to a Nifty 50 index fund (Note: The Nifty 100 index fund also has a minor technical issue. But since I intend this to be a simple article targeted at laymen, let’s not go into that). Similarly, index-like debt mutual funds that have a high duration and material interest rate risk could be useful in a portfolio. But for the sake of simplicity, I have ignored them.
I have focused on products that have the lowest fees which are the most important factor. "I have ignored products that are targeted at retail investors and/or have higher fees. For example, I have ignored the Nifty 100 index fund.
Due to subjective reasons, it would be good to limit the investment via each MF house to around 10-15% of your net worth. Hence multiple identical products are useful.
In simplistic terms, Smart Beta is the belief that investing in small-cap stocks or momentum stocks or stocks with a low Price-to-Book ratio etc will allow you to beat the index on a risk-adjusted basis (i.e. generate alpha).
In reality, Smart Beta products do not beat the index on a risk-adjusted basis i.e. they do not generate alpha. The Nobel prize winner Eugene Fama who is the brain behind the smart-beta strategy has himself said that any additional expected return from a smart-beta strategy comes from higher expected risk. So, I have rejected all such unnecessary and relatively high-cost products e.g. ‘Sundaram Smart NIFTY 100 Equal Weight Fund’ and ‘ICICI Prudential Nifty Low Vol 30 ETF’.
You should not treat this article as investment advice. You should only treat it as an illustration that you can construct a portfolio entirely using index funds and index-like funds (apart from bank deposits and some products where the government offers a high-interest rate).
Only for the sake of simplicity, this article ignores funds that invest outside of India. Above a certain net worth and if you are open to some complexity, it may be worth evaluating funds that invest outside of India.
At a marginal (i.e. peak) income tax slab of less than 20%, debt mutual funds do not make sense. At 20%, they may or may not make sense i.e. it is ambiguous. At 30% they make sense if you can stay invested for 3+ years.
Stop being a hostage of the MFs and stop playing the game that they want you to play! All your domestic MF investment should be in index funds and index-like funds with fees of less than 0.20% p.a. In summary, follow the Bogleheads approach to investing.
A few other relevant articles by Avinash:
The two-headed Goliath—Mutual Funds and their distributors — Exorbitant annual fees and commissions to distributors are hurting Indian mutual fund investors. There is a solution, but don’t expect your local distributor to tell you about it (This article is behind a paywall but a few excerpts are available here).