The case for passive investing

The passive-investing strategy says that investors should invest continuously and systematically in broad diversified indices, while ignoring the current market level and volatility. This method guarantees an index return, which should beat inflation.

The passive concept became popular once the efficient market hypothesis (EMH) was developed. The EMH claims that in an efficient market, it is difficult to consistently outperform a broad well-diversified index. A market is considered efficient when information is rapidly disseminated to all and there is equal ease of trading for everyone. In such an efficient market, new information is rapidly discounted and prices move unpredictably. (This is a very brief definition).

Burton Malkiel, author of A Drunken Walk down Wall Street, is one of the most passionate advocates of passive investing. He has made many interesting statistical observations to support his arguments. The 'drunken walk' is a figure of speech that compares the way stock prices move to the way a drunkard weaves around.

Some markets are more efficient and no market is perfectly efficient. But there is a high psychological and practical advantage to passive investing in almost any market. Assuming the investor has the mental discipline to do this, he or she can take comfort from an automatic process.

There is no need to think about the index level or daily prices or what is happening in news flow; there is no need to pick stocks that may or may not be outperformers. Over time, the investor will receive the same return as the index.

This method also ensures continuous investment. Some part of the investor's savings will continuously flow into equity. It is tax-efficient since long-term capital gains tax is low in most countries and it is non-existent in many places, including India.

There is a lot of statistical data to back up passive-investing strategy. One statistical argument is as follows. No stock market move is smooth. Bull runs are driven by surges on specific days rather than by a steady gain. If the investor is not in the market on big bullish days, the returns are much reduced.

Somebody who is not continuously invested will suffer a high chance of missing at least some big up days since nobody has a perfect method of timing the market. Of course, being continuously invested also means taking losses on 'down days'. But overall, in a gaining market, there will be more up sessions than down.

Since January 2010, this seems to have been true for the Nifty. There have been more up days than down; the average return on an up day is higher than the average loss on a down day. However, the maximum loss on a down day is higher than the maximum gain on an up day. This also fits with another statistical assertion. The Nifty has moved from 5,200 to 8,500 in that time, and an SIP across that period (January 2010 to July 2015) offers 13.3 per cent CAGR.

Recoveries from the bottom of bear markets tend to last longer and return more than falls from bull market peaks. That is, let's say an index peaks out at 1,000 points, plunges to a low of 550, recovers again to 1,000 and carries on to a new high above 1,000. According to Malkiel's data crunching, the down move from 1,000 to 550 (or 45 per cent loss) should take less time than the subsequent recovery from 550 to 1,000 (or 82 per cent rise). This is despite the fact that the nominal magnitude of both moves (450 points down/up) remains the same.

Part of this difference is explained by 'percentage mathematics'. It takes longer to double something (+100 per cent) than to knock off half the value (-50 per cent). Also, a decline can never erode more than 100 per cent of value, whereas a rise can double, triple or quadruple values. There is no upper limit to gains, in theory. Up moves usually last longer as a result.

There is also an underlying psychological factor that probably influences this. Bear markets induce panic, whereas bull markets induce euphoria. Panic causes people to sell out quickly and then to stay away from the market, leading to steep crashes. On the other hand, euphoria causes successive waves of buying, which can sustain rises for long periods, way beyond the point where valuations can justify them.

The most recent big moves in Indian markets conform to this idea. The second-last bear market started in January 2008 when the Nifty peaked at 6,357. The index hit a low in October 2008, when it bottomed out at 2,252 for a retraction of 65 per cent over a period of just eight months.

The subsequent bull market hit a high of 6,338 in November 2010, which was a climb of 180 per cent in 25 months. The next and so far the last bear market that India has experienced hit a low of 4,531 in December 2011, which was a correction of 29 per cent in 13 months.

Since then, the market has not seen a major decline, though there was a long period of sideways movement. The current bull market hit a high of 9,119 in March 2015 - a return of 101 per cent in 39 months. Since then, it has corrected but it's still trending at over 8,500 at the time of writing. The return on a monthly SIP since 2008 would be 12.5 per cent CAGR.

Bull markets do last longer and traverse greater distances. Bear market declines often have steeper slopes. This is, in itself, a strong argument for staying continuously invested. The longer you are invested (ideally continuously), the better the chances of picking up the entire returns from each bull run. Of course, this also means ignoring the losses from a bear market as and when there is a steep correction.

A third argument in favour of passive continuous investing is that investors are guaranteed to make errors in stock selection. Any active strategy must pick outperformers and weed out underperformers. However, the best-performing businesses of the past will not necessarily be the best-performing businesses in the future. The chances are, some underperformers and some new businesses will come to the fore in every new rally and nobody is going to get it right on every stock pick. Why worry about what stock to pick when you can just buy a broad index?

However, this is one place where empirical results suggest that there can be an upside to being an active stock picker. A few stock pickers do seem to beat market indices consistently. Even in developed markets, like the US, where very few pickers beat the market consistently, some nevertheless do. The numbers there are so small that the results could be more or less attributed to luck. However, it is also possible that the few active players who beat the market do have something common in their style and approach to stock picking.

In emerging markets, which have far more trading imperfections and more information leaks than developed markets, a far larger number of stock pickers do beat the markets regularly. In fact, quite a few active Indian mutual funds have consistently beaten the Nifty. The five-year CAGR for July 2015 over July 2010 is 9.6 per cent. A look at top-rated active funds on the Value Research website will indicate a fairly large number of active funds have hit double-digit returns.

There's an interesting call to be made here. If the imperfections are going to be ironed out of Indian markets, the number of outperforming active funds will dwindle. On the other hand, if the imperfections remain, it is worth holding a bunch of active funds with consistent outperformance records.

As a dyed-in-the-wool cynic, I would assume that the imperfections will remain. It would take an enormous effort to even begin to reform processes across multiple areas to smooth out imperfections and leaks in Indian markets. I don't see that sort of effort being made.

This means that investors with an information edge and more analytical skills will continue to beat the indices. So mutual funds with good track records will remain worth following and systematically investing in, since their performances suggest these do have an information edge.

The writer is an independent financial analyst.

This column appeared in the August 2015 Issue of Wealth Insight.