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S. Balakrishnan

THE theory of efficient markets is now old hat.

What it says is simple. No individual - lay investor or fund manager - can outperform a market index for any continuous length of time. This is because all available information - about the global and domestic economies, an industry and a company - is contained in today's stock prices.

In other words, there is no under or overvalued situation in the market. The prevailing price of a share reflects all - its history, current prospects and future.

So stock picking is a futile exercise. Some investments will succeed, many will fail. At the end, all that can be hoped for, at best, is the market return; more often it will be below that.

In the US, decades of research and analysis of decades of data on the performance of mutual funds have led to the more or less irrefutable conclusion that active investment management does not even yield the market return. So all the fancy strategies and fees charged by fund managers translate into nothing.

Hence, the popularity of index investing. Index funds invest in index stocks exactly in the proportion in which they are present in the index.

As there is no research and stock picking involved in index investing, management fees are extremely low compared to active investing.

The investor is sure the return will, at least, not lag the market.

Index investing is all the rage in the US. There are a large number of index funds, competing on low fees and tracking error (the difference between market return and that on the index fund).

In India, in contrast, index funds do not seem to have caught on, possibly because of investor ignorance and the lack of interest of mutual funds in pushing an investment strategy, which, after all, deprives them of any significant role in fund management and justification for high expenses and fees.

Still sceptical of efficient markets and index investing? Try comparing the returns from just buying and holding the Sensex or Nifty basket of stocks from mid-2003 to date and actively-managed mutual funds. How many can match the staggering appreciation of 250-300 per cent (excluding dividends) in the market indices in the last two-and-a-half years, which would have been the result of a purely passive strategy of index investing.

Of course, there is a paradox here. It is only the diligence of equity analysts, which leads to the right valuation of stocks. If there is no research, the market will abound with opportunities.

But for the marginal investor, index investing seems to be the answer.

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