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Why index funds and ETFs are not very popular


Index mutual funds (MFs) and exchange traded funds (ETFs) are great products, at least theoretically. But can the same thing be said at a practical level? Are enough retail investors getting around to investing in these funds?An index MF tries to mirror a broader stock market index by investing in stocks that constitute that index in the same proportion as the weightage of the specific stocks in that index. Given this, the returns on such funds are closer to the overall return of the broader market index. Further, an ETF is an index fund that can be bought and sold on a stock exchange.

As of January, the total amount of money invested in index funds and equity ETFs stood at 4.3 trillion. The total amount of money invested in actively managed equity MFs was at 15.1 trillion. Thus the amount of money invested in index funds and equity ETFs was at 28.3% of active funds. This sounds quite large.

But a lot of money invested in the four largest equity ETFs is institutional money coming in from the Employees’ Provident Fund Organisation (EPFO). Ultimately, the money invested by the EPFO is also retail money being invested into the index. But this isn’t an active choice being made by the retail investor.

Once we ignore the four largest equity ETFs, the total amount of money invested in other ETFs and index funds, stood at 1.3 trillion. This is around 8.4% of the amount invested in actively managed MFs and a better representation of active choice. A disclaimer needs to be made here. There is some retail money invested in the four biggest equity ETFs and there must be some institutional money invested in other equity ETFs and index funds. There is really no way one can adjust for this.

Nonetheless, there are 202 other equity ETFs and index funds. Of these, 196 funds have total investments of less than 5,000 crore. This implies that a bulk of money invested in these funds is basically retail money.

Clearly, not enough retail money has been invested in index funds and other equity ETFs. Why is that the case? One school of thought possibly can be that, in the Indian case, many actively managed equity MFs have done better than the broader index like a Nifty or a Sensex. This is true. Nonetheless, there is a small problem with this argument. It is made with the benefit of hindsight.As Eric Angner writes in How Economics Can Save the World: “After the fact, you can always identify individual stocks or funds that outperformed the market and did better than the index. But before the fact, you can’t dependably identify which one it’s going to be.” Clearly, most retail investors do not realize that such a risk exists.

Further, what economists call the availability bias is at work. When was the last time you saw a story in the media about someone who got rich investing in index funds? As Angner writes: “Stories about successful investment strategies are legion. You read them in the financial press and business magazines, under headings such as ‘How I got rich’…I can’t recall ever reading a story about somebody who made money investing in index funds.”

Further, many investors seek excitement and a meaning in their lives while investing. The index funds and ETFs are boring and can’t deliver on those parameters.

Anyway, the fact that the retail investors are bombarded with the kind of content that they are, leads to an availability bias. They see stories of people getting rich by investing directly in stocks, in actively managed MFs, in futures and options, in cryptos and so on.

So, when it is time to plan their own investment strategy, these are the things they end up investing in, because this is the material available in their minds; the material on the basis of which they make their investment decisions.

The good thing is that the proportion of money going into index funds and other equity ETFs has gone up a little over the last few years. As of March 2021, the total amount of money invested in other ETFs and index funds (adjusted for the top 4 ETFs) had stood at 50,560 crore or around 5.2% of the money invested in actively managed equity MFs at that point of time. Now, as mentioned earlier, it has gone up to over 8%. Hopefully, in the years to come, this will keep going up further.

 Vivek Kaul is the author of Bad Money.

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