Infosys vs. Index Funds: Pick Stocks or Buy the Market? 

Hello everyone, Rahul Shah here, trying to make investing accessible and profitable for the average investor.

Warren Buffett's most famous advice is that of buying companies with strong moats when they are available at reasonable valuations.

Do you know his second most famous advice? It is to buy a low-cost index fund.

Yes, that's correct. Buffett has built all his wealth by actively investing in stocks.

And yet, he is asking the average investor to not be an active but a passive investor.

Here's what he once said.

• In my view, for most people, the best thing to do is own the S&P 500 index fund.
  
  The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently and to do it in a very, very low-cost way.

Guess who's taking Warren Buffett's advice seriously?

Well, it is none other than the Indian mutual fund industry. As you would be aware, the Indian fund management industry is on a fund launching spree.

And why not. With the way the sun is shining on the Indian stock market, the industry wants to make as much hay as possible.

A leading daily reports how as many as 170 new funds have been launched this year alone.

What's even more surprising however is that out of these launches, passively managed funds accounted for the largest number. Yes, that's true.

As many as 42 index funds and 36 ETFs (Exchange Traded Fund) were launched this year so far. Both index funds and ETFs can be categorised as passive funds.

This makes passive investment funds the single largest category this year, by far.

Before we go further, it is important that I tell you the difference between active funds vs passive funds.

Active investing means investing in funds whose portfolio managers cherry pick each stock in the portfolio by doing deep research on its fundamentals and its valuations. Th goal of an active manager is to beat the benchmark index like the Sensex or the Nifty.

Passive investing on the other hand does not believe in cherry picking each stock but simply buying all the stocks in a given market index.

For e.g. passive investing in a Nifty index fund would mean buying all the Nifty stocks in the same proportion as they are present in the index.

The goal of a passive mutual fund is to not beat the benchmark index but give the same returns as earned by the index.

Ok, with definitions out of the way, let us proceed with the rest of the discussion.

It is said that active investing is not worth it if you are not earning at least 3%-5% points better than the benchmark index.

In other words, if the benchmark has returned say 15% per annum over the last 10 years, an active investor or fund manager should return at least 18%-20% per annum post fees.

Are active fund managers up to the task though? Have they managed to beat the respective benchmark indices by at least 5% points per annum?

Let's find out.

Do you know how much has the BSE 100 gone up over the last 10 years? Well, it has given a CAGR of 13% in these last 10 years. It has grown investor wealth at 13% per annum over 10 years.

Next, I went to the Moneycontrol website and found 23 active large cap funds that were of age 10 years or older.

And do you know what is the 10-year average return of these funds? Well, it stands at 14%. Over the last 10 years, an average active large cap mutual fund has grown investor wealth at 14% per annum over 10 years.

So, the BSE 100 large cap index has given 13% CAGR over 10 years and the 23 large cap active funds have earned 14% CAGR during the same period on average.

As I said earlier, active investing may make sense if the returns are atleast 3%-5% higher post fees.

In other words, the active funds in India could have been termed successful in my book if they had earned 16%-18% returns per annum on average. However, they have failed to do that.

And here's the interesting part. No fund has managed to achieve 18% CAGR returns over the last 10 years and only two funds have given returns of 16%.

In short, active fund managers have given a poor account of themselves over the last 10 years.

Little wonder, more and more passive funds are being launched in India every year. After all, if active fund managers can't beat the index over the long term, there is hardly any sense in paying them active management fees.

So, does this mean that an investor should give up active investing all together and completely move towards passive investing?

Well, back in 1984, Warren Buffett gave a wonderful presentation titled 'The Superinvestors of Graham and Doddsville'.

He spoke about a group of 10-15 investors who were all active investors and who had all managed to outperform the benchmark index by 5% or more over the long term. In other words, these people had figured out the secret sauce to outperforming the benchmark index on a consistent basis.

And what was this secret sauce? Well, they had all learned value investing under their mentor Benjamin Graham.

You sese, Benjamin Graham had laid out three very important rules besides other things.

These rules were to treat each stock as a business and try to find its intrinsic value, to think of Mr Market as a moody follow who keeps vacillating between fear and greed and last but not the least, always insisting on an adequate margin of safety while buying stocks.

All the 10-15 superinvestors that Warren Buffett spoke of, followed these 3 principles of Benjamin Graham as closely as possible.

They each had a portfolio comprising of different stocks, but each stock was bought after calculating its intrinsic value, by being greedy when others were fearful and incorporating a significant margin of safety.

Put differently, they had different techniques of buying stocks, but the underlying principles were similar and came from Benjamin Graham.

Well, if you wish to be an active investor and you want to outperform the market by at least 5% per annum then you will do well to follow Benjamin Grham and his principles.

Buy only those stocks where you have a good idea of the stock's intrinsic value and buy them when the other investors are being fearful of these stocks.

Lastly, also incorporate a suitable margin of safety so that even if you go horribly wrong in your assumptions, your downside is limited.

As Warren Buffett once said, follow Graham and you will profit from folly rather than participate in it.

Happy Investing.