Index Funds - Things I did not know

General
1

Few days back I read an article in Money control about index fund. Tried to search for this article which I could not find. The author says, in a nutshell, that the constituents of index funds are not the best of the companies in India, it is only because of free float etc.

This made me start reading article about index fund and found this. To summarize the main points.

  1. Index funds buy high, sell low.
  2. Index funds stick with stocks till they’re kicked out
  3. Index funds buy the past, ignore the future

I always though index constituents such as Nifty 50 stocks are the best companies in India

I knew Sl.No2 when the Adani - Hindenburg saga came out. Point No.3 is also kind of I knew, but Sl.No.1 Did not know.

I read many articles earlier on Index Funds and no one mentioned this as a negative.

Even the article in varsity about index funds does not cover these points. I guess the articles there are never updated.

2

I wouldn’t read much into the opinions expressed in the linked post
as it is very narrow-minded about what an index fund it.

So as a company gains in market capitalization (and thus gets expensive in terms of valuations like price-to-earnings or price-to-book value), the index fund manager has to buy more of it to get it to a higher weightage in his fund as well.

The entire post appears to be written with a very particular index fund in mind,
whose constituents (and their weightage in the fund) are defined simply based on market-cap,
and are already the largest by market-cap.
For example, the NIFTY50 index.

There are other indices that

  • do not use market-cap alone to determine their constituents.
  • do not weight the individual constituents based on respective market-cap.

Each of the 3 claims mentioned in the linked post
can be systematically dismantled/disproven,
if one thinks about the claims for more than a few seconds.

1. Index funds buy high, sell low

The nuance being missed is -

  • Buy what is reasonably high.
  • Hold what goes higher.
  • Sell-off what doesn’t, thereby limiting one’s losses / opportunity costs.

Isn’t this precisely what most active-trading is anyway?

2. Index funds buy the past, ignore the future

Again, the fact that a company features in an index doesn’t automatically mean that the company is at it’s peak. Think of midcap indices.

Also various indices have different rebalancing periods.
At what point does one consider an active fund to be over-trading compared to a relatively frequently rebalanced passive index fund?

3. Index funds stick with stocks till they’re kicked out

Compared to what alternative?
Holding on to a stock until it drops to zero or stops being traded?
the post goes on to describe how active fund managers do the same slightly sooner.

It will be interesting to find out over the long-term (not individual instances),
if there are any relatively higher returns due to the active funds ditching sooner (compared to index funds) any constituents soon to be exiting the index,
and whether there is any additional gain left over in such scenarios AFTER accounting for the higher expense-ratios of active funds relative to passive index-funds.

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3

I will counter the points made in that article with two examples of stocks that were recently removed from the Nifty 50 in the latest rebalancing—BPCL and Britannia.

BPCL was added to the index on October 28, 2002, when the stock was trading at around ₹20. Currently, it is trading at approximately ₹230. Over this period, the company has issued three 1:1 bonus shares and one 1:2 bonus share, along with an annual dividend yield of around 10%.

Britannia was included in the index on March 29, 2019, at a price of around ₹3,000. Today, the stock is trading at approximately ₹4,500. Additionally, Britannia issued 1:1 bonus shares in August 2019 and May 2021. While its dividend payouts may not be significant, even without considering them, the stock has delivered a remarkable 500% return in just six years.

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4

@Jayadratha That’s a great observation. :+1:t4:

So, basically, even when some company’s market-cap gets overtaken by another,
and the company’s stock is being removed from a “top-N-by-market-cap” index,
it is incorrect to assume that the company’s market cap reduced
or that one made a loss holding it over the years. Nope. Not necessarily true.

(in this scenario, it’s just that there are other faster gainers right now,
and they are now being included in the index instead.)

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5

The above point is valid though. Whether the buyer buys or not at whatever level is her perogative.

I buy US related ETFs irrespective of the premium to iNAV, this is my strategy and I presume, I understand all the features of the ETF product. I am invested in Nifty 50 ETF but was not aware of this point. I will continue to buy Nifty 50 ETF in future as well, but I am aware now of this feature as well which no article which I had read mentioned. This is the only point.

I knew Sl.No.2 but experienced it live when one of the adani stocks in Nifty 50 was falling and nothing could be done on that but to wait and watch. Thank God the weightage of that stock was low.

Similar thing happened when I was reading about momentum investing, I think it was you who had mentioned that there is a risk of buying the momentum ETF when the constitutents were at high level and need to hold until the next rejig by that time the value of a constitutent could fall drastically. None of the article which I read on momentum investing had this point . This made me rethink and stopped short of investing in momentum ETF

Just like varsity says when buying ETFs, always put limit price and not market price, I have bought ETFS which I wanted at market price, but I know the risk of putting a limit price.

6

I disagree.
The statement is a over generalization.
It is similar to saying traders buy high and sell low.
Of course, they do. Sometimes.
And a successful trader

  • does “buy high, sell low” less often than buying low and selling high.
  • has their magnitude of their losses less than the magnitude of their gains.

The key takeaway from that article for me,
was that passive indices (and ETFs) are not a “100% right all the time” foolproof approach.
Which nicely brings us to the point that…

…this is expected.
Nothing to worry about or panic-sell a passive ETF during such a scenario.
This is similar to a stop-loss being triggered. Relax. It is working as expected.

An even better analogy might be
having purchased a security hoping it will move up, and placed a stop-loss limit,
one need not over-think if the security starts moving down contrary to expectations.
If it meets the stop-loss threshold it will be sold with a limited loss.

In case of passive-ETFs, the “stop-loss” is not very nimble
(doesn’t trigger within minutes or days)
and is time-triggered based on how often the index is rebalanced
(typically 3 or 6 months).

This behavior of ETFs following passive indices can also be helpful to reduce losses
by avoiding booking losses during short-term volatility.

If anything,
assuming one is into the ETF to diversify their holdings,
one should have liquidated some (all?) of their holdings of an ETF
when a single constituent became a huge % component of the underlying index,
even before there’s any news/suspicion of a major constituent falling in the near future.
Of course, in the above scenario, the stock that fell wasn’t a major constituent,
and hence one was justified in continuing to hold the NIFTY50 ETF.

Advantage of a market-cap weighted index, right?
Constituents that are close to the bottom of the index,
end-up being a appropriately weighted smaller % of the Index.

Basically, If one has “back-tested” a strategy,
(even if it is one that is laid out publicly in a passive index’s methodology document)
there’s nothing to worry about when a contingency “stop-loss” scenario is triggered,
especially when it is as per the pre-defined contingency logic laid out in the strategy.

This discussion serves as a good reminder that
wrapping a passive index around equity
doesn’t make it a linear, appreciation only asset.

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7

On the topic of impact costs on ETF
during the period of an imminent periodic index rebalancing
due to some of their trades involving the passive index constituent stocks being sunshine trades -
image

Here’s an article (for the US ETF markets, in 2022)
that focuses solely on how ETFs tracking passive indices
fail to opportunistic folks trading on known public information for days before an imminent periodic index rebalancing.

Soon after, this other article was posted
with clarifications from ETF industry insiders
highlighting some of the incorrect assumptions about passive ETFs.

“They can execute through an investment bank and get a guaranteed execution on close, so there are many flexibilities in reality and ways to take into account liquidity, size, trades coming up, or market moves,”

“Many index funds will attempt to preserve shareholder value when rebalancing due to an index change, which often means trading before or after the effective date of an index change.

“This can benefit fund investors by reducing transaction costs or associated market impact of the fund’s trading. Index fund managers will weigh the potential transaction cost savings against the risk of an increase in tracking error to determine an optimal trading strategy around an index change.”

The main clarification being that
fund-managers of ETFs tracking passive indices do not get outplayed during index rebalancing, i.e. they aren’t sitting with their hands tied doing nothing while the market reacts to the imminent entry/exit of stocks from the index during the upcoming index rebalancing.

Probably someone who knows more about Indian ETF markets
(@Meher_Smaran? @VishalJain?) can comment on
how much flexibility is available to fund houses offering ETFs tracking passive indices in India,
to minimize impact costs during index rebalancing?

8

On the topic of periodic index rebalancing of NIFTY50,
how well do the constituents being removed perform compared to the ones being added ?

Based on the provided data,
Out of these 19 stocks (removed from the index),
6 managed to generate positive returns over the following one-year period,
while the remaining 13 stocks experienced negative returns.

When examining the performance of the added stocks within the Nifty 50,
11 generated positive returns ,
while the remaining 8 of them delivered negative returns.

image
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Source: Complete Nifty50 rebalancing analysis since 2017

Note: A deeper analysis of the impact on the index, should also account for

  • the relative weightage of the constituents replacing and being replaced.
  • and also the magnitude of their gains and losses (not just whether +ve/-ve).