Monday, May 23, 2016

Investments in Indices can be sold - no dilemma in sell decision

This article is in fact a continuation of the debate initiated in the last article, "Buying shares is easy - decision to sell is the most difficult".  I advise readers to first read the previous post and then continue here.

One can buy or invest in an index like BSE Sensex, NIFTY and NIFTY Junior, etc., through what are called exchange traded funds (ETFs).

Investment in indices are recommended for lay investors (not value investors) as it gives security through diversification.  On the contrary value investors create concentrated portfolios comprising of not more than 20 stocks, after thorough research.  But a value investor may invest in an index fund two reasons, as follows:

  1. As a hedging strategy or in other words as a buffer against risk and/ or;
  2. To evaluate the performance of her own portfolio against the index;
Our example portfolio 2K15 is built exactly for these reasons, besides to be used as a practical teaching tool.

In my previous post "Buying shares is easy - decision to sell is the most difficult", I had explained how complicated is the decision to sell.  But, when a value investor builds a significant portfolio of index funds, he may sell this portfolio and book profit when the market is in an unreasonably bullish or enthusiastic zone.  He can simply buy the same index when the market falls and moves into unreasonably pessimistic zone.

All the objections to sell raised in my earlier post do not apply in the case of a portfolio of index fund because of the following inherent reasons/ differences between value investing portfolio and an index fund:

  1.  No midnight oil burning research has gone into building the portfolio - the companies get included in the index simply based on the highest market cap, which means the criteria for inclusion is market's opinion about the scrip and not based either on the companies' fundamentals or fairness of valuations;
  2. Investors in index based funds do not get any meaningful returns by way of dividends. Managements of most of the constituents of the indices in India, like BSE Sensex and Nifty 50, pay negligible portion of their profits as dividend, usually 10-12%.  Considering that these scrips are priced unreasonably higher, the dividend yield (dividend per share divided by price) is abysmally low.  Under these conditions, the only way an investor can earn a return on his investment is out of price movements - that is buying when price is low and selling when price is high.  On the other hand since the scrips constituting a value investor's portfolio yield a regular and handsome dividends in addition to capital appreciation on the back of companies' growth, there is no need to sell the shares;
In conclusion, there need not be any serious dilemma in a sell decision of index funds as opposed to constituents of a value investing porfolio.