International Diversification And The S&P 500 – How Do You Care?
Come, travel with me all the way back to 1957 and let me take your mind off the current dismal situation in the world.
It had been 12 years since the Bretton Woods conference which had sealed the fate of the American Dollar as the reserve currency for people to trade in. America had begun to flourish. In the offices of Standard & Poor, the creation of Standard 500 was announced. It was an index to represent the performance of corporations across America. There had been attempts in the past but now, a newly-found technology was to enable the firm to perform index calculations more effectively. This index was to later evolve into what is widely regarded as the best representative of the U.S. stock markets. The S&P 500 as it is known today, is broadly diversified across sectors. There are strict parameters that determine which companies are to be on it. Weightages are calculated in a responsible manner and one can say that it is quite a model for index construction.
In 1976, John Bogle of the Vanguard group created the first index fund that would simply track the S&P500 Index. History was made and ‘passive investing’ was born. One could buy an index fund and participate in 80 percent of Corporate America’s performance, inclusive of dividends and be done with it. Those who did not believe in indexing continued to invest in active funds – where fund managers would attempt to beat the index.
This was the era of legendary fund managers like Peter Lynch – a time when superior stock-picking skills had a big role and were still an identifiable attribute. In 1977, Lynch took over the management of the Magellan fund at Fidelity and went on to manage it for 13 years. Of those 13 years, he beat the S&P 500 for 11.
Around the time Peter Lynch retired, financial markets had evolved and advanced in many ways.
Technology had become more cutting-edge; information was more easily available and more and more trained professionals were joining the profession. Passive investing continued to exist - parallel to active, in what can be called peaceful circumstances.
But that was to change.
In 2003, S&P, the index manufacturer started publishing a scorecard. It recorded the performance of all active managers across the globe and compared them against the indices they were benchmarked against. That marked the beginning of a debate - popularly known as SPIVA - the S&P Index Vs Active. The SPIVA scorecard is now published twice a year and is a revelation of sorts but more about it later.
About a decade later, in 2013, Michael Mauboussin and Dal Callahan of Credit Suisse published their seminal paper – Alpha and the Paradox of Skill. They made some significant findings and assertions.
Very simply put, ‘paradox of skill’ is the phenomenon where increased skills in an area of expertise, decrease the chances of witnessing any outlier performance. The duo studied the performance of U.S. large-cap active funds for the last 45 years and concluded that this phenomenon was true for the investing world as well. Even in 2013, the S&P 500 was becoming increasingly difficult to beat consistently. If you are mathematically inclined, do read the paper – it is a treat and asserts the increasing role of luck and the declining role of skill even when there is outlier performance in bits and spurts.
Today, there is data on the table. The chart below offers some index versus active data in the U.S. markets.
What this simply says is, as of December 2019, more than 80 percent of funds have underperformed the S&P 500 over the past five years.
Index investing today has an overwhelming place in the U.S. markets. More and more wealth managers are beginning to concede that they may not be able to identify which small proportion of fund managers will outperform the omnipotent S&P 500 – simply because they do not consistently manage to do so. Those who do, don’t do it often and their outperformance cannot be attributed to skill.
Here is a little timeline for you to recap all that information.
Why Should All This Matter To You As An Indian?
A. Here is my story. I am currently writing this on an Apple laptop. It does not come with an inbuilt Microsoft Office Suite so I have paid for one, I habitually shop at Amazon. Those are the top three holdings of S&P500.
We have grown up using and gifting products by Johnson & Johnson and watching Walt Disney. Ever since I started earning, I have been swiping credit cards that use the Visa and Mastercard gateways. The only medication I use is manufactured by Abbott. Coca Cola and PepsiCo and McDonald’s have taken over the lives of young people I know. I use Paypal for some international receipts, I pay a hefty sum to Netflix every year.
Excuse me if I am a little excited to be able to buy these stocks, and more – firms whose products I don’t use but I know for a fact are important corporations, legendary even. Berkshire Hathaway, JPMorgan, Procter & Gamble, Costco. Okay, now I will stop.
B. The hapless Indian rupee. I have heard all the arguments about how the U.S. dollar will perish as a reserve currency, that it is now merely legal tender, no longer backed by gold. I have read pages of research on the burgeoning U.S. public debt, the mindless printing of currency and how various other superpowers are gaining ground on international politics and trade, ready to take on the United States of America. While all this has been written, talked about and read, the dollar has appreciated against my home currency, the Indian Rupee at a compound annual growth rate of 3.7 percent!
While I have been getting wiser, some people have been getting richer.
Even the Thai baht has appreciated against the Indian rupee for heaven’s sake. That is how exciting our home currency is. If that does not call for diversification, I don’t know what should.
C. If I had participated in both markets, how would I have fared? There are various ways of showing you this data but I am borrowing a slide from a Motilal Oswal presentation.
On an absolute rupee-basis, take a look at how S&P 500 and Indian markets have done over the last 10 years.
If You Wanted To Participate In The S&P 500, What Are Your Options?
If you have the means, the understanding and the ability to open an overseas broking account, you could remit money via RBI’s Liberalised Exchange Rate Management Scheme, and buy any major index or an ETF listed on the New York Stock Exchange. Unless it is a meaningful sum of money, I suggest, don’t bother. It is a tedious process, calls for additional compliance and is widely tracked by authorities. A few thousand or even lakh really do not need to be remitted to buy the S&P 500. Also, if your wealth is in any corporate format – a limited liability partnership or the like, then LRS is not available to you. You can read all about it here.
One would wonder why our mutual funds have not found a way yet. I spoke to some and figured, even those who see the need, find the process of collecting Indian rupees, remitting the money and investing in a foreign stock exchange quite challenging.
A vast majority of the others are still stuck at the stone-age argument that India is where all the growth is, so even if we have inflation and a depreciating currency, all the world’s money will come to us and we will go to the moon and hence there is no need to diversify.
Some have opted for a feeder option within the group and gone ahead with it. No one has embraced a pure-play passive option in the S&P 500 so far. Motilal Oswal AMC is finally attempting it. They are going to launch the New Fund Offer on April 15, 2020.
Now here is the thing – the process is layered and challenging. This is to say, that there will be tracking errors. The difference in stock market timings, the lot size that a U.S. broker will prefer to work with vis-à-vis our minimum investment amounts in India, running an open-ended index fund linked to a foreign exchange, are all, operational difficulties. Even so, if anyone has any prior experience of doing this, it is them. They have been managing a Nasdaq 100 ETF since 2011. The challenges, the learnings, and the existent structure are all positives for them.
You could be a nitpicker, sit on the sidelines, take a view on the U.S. markets or you could go with them.
Fun fact: Once the fund opens for subscription, you could wake up in India on the morning of say May 15, look at how the U.S. markets did and invest. You will get the NAV that has been declared at 9 a.m. India time as that is the value which corresponds to how the markets did on May 14 in the U.S.
What About The Current Economic Outlook?
Thanks to Covid-19, it does look like we are in a bit of a fix. As I sit alone, locked down in my apartment overlooking an empty street, reminiscing the importance of ‘society, friendship, and love, divinely bestowed upon man’; I watch with amusement how some people are invoking memories of the 2008 global financial crisis. My rational mind has rejected that this is comparable to those times. Handling the failure of a few financial institutions, no matter how big or how intertwined with other global institutions, was after all, a ‘financial’ crisis. It was one that may have been tackled with financial measures and means only. This is hardly the same.
The ongoing worldwide health crisis may bring about a massive dislocation of what we know as equilibrium.
I am not sure if we can even forecast its consequences correctly. Once this ends, we could emerge frustrated, distant and distrustful. Or we could get back to work with vengeance, put in our best and emerge a resilient people, stronger, indefatigable. I have great faith in the human spirit and will vote for the latter. Therefore, I am buying indices in both markets, India and the U.S.
As long as the world has a working population, a few bankruptcies aside, production will start again, wages will be paid and demand will be created. Equity markets are a reflection of how corporations perform. While there may be a recession, as there surely will be, so will a revival. I am going to be invested and wait for a new equilibrium. There will be one.
Abaneeta Chakraborty has close to two decades of experience in managing money for ultra-HNI families. She founded the firm Abanwill Consultants LLP in 2017 to provide independent views on investing. This review of the upcoming ‘Motilal Oswal S&P 500 Index Fund’ follows a independent study by the author of the Scheme Information Document and Scheme Additional Information; and extensive discussions with the asset management company.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.