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Fund managers vs algorithms

business Updated: Sep 16, 2007 23:44 IST
Fund managers vs algorithms

One morning last week, as I sat in my car waiting for a green light at a crossing in an area full of government offices, I idly wondered whether any of the hundreds of babus crossing the road knew that they’d just become investors in a hot real estate stock. Or rather, they would, if the new pension system were to be implemented thoroughly.

This would happen because equity investments under the new pension system would be done through a fund that would be an index fund — and that very morning I had read that Unitech had been added to the National Stock Exchange’s (NSE) premier Nifty index. The news of Unitech being added to the Nifty really caught the eye because it was not too far back that the stock was considered a fairly adventurous one, in a manner of speaking. On the other hand the Nifty (‘the stock of the nation’, according to the NSE’s own advertising) is generally expected to be the abode of non-adventurous stocks — again, in a manner of speaking.

Now I’m sure that adding Unitech to Nifty is just fine by the stated norms for the Nifty’s composition. As the NSE website explains (in an FAQ that is shockingly well-written by the general standard of such webpages), the stocks in the Nifty are chosen algorithmically as the fifty most liquid stocks by a certain way of measuring liquidity. I guess if Unitech turns up in that list then that’s that. The BSE Sensex, on the other hand, appears to be more of a committee-driven creature. The BSE does have some liquidity and other norms but it’s clear that index’s composition is essentially subjective.

However, in my mind, this does bring up the question of index fund investing and treating indices like investment portfolios.

Index funds don’t involve any research or active investment management—what they invest in is automatically decided by the index. Except that, as we’ve seen above, the word ‘automatically’ is not really suitable. The index is chosen by people. Perhaps by a committee, or by a committee reading the results of some algorithm designed and chosen by people. Perhaps that algorithm produces results that are correct in a statistically satisfactory proportion of cases. Perhaps any process, whether committee-driven or algorithm-driven, produces a large number of correct cases and a small number of mistakes. And perhaps, as in physics or in rainy-day cricket’s Duckworth-Lewis method, we should be aware that using the results of a system can itself modify that system. After all, Unitech’s liquidity seems to have taken a major jump ever since its ‘liquidity-induced’ inclusion in the Nifty was announced.

All of which leads me to conclude that the frequently-predicted death of active investment management is a long way off. The NSE’s indices FAQ says that “Movements of the index should represent the returns obtained by ‘typical’ portfolios in the country”. I guess the quotes around ‘typical’ creates some wriggle-room but if one considers mutual funds as typical portfolios then across all periods, a good majority of funds beat the indices handily. Given what I’ve observed above, the reason is not difficult to figure out. The competition is not between active fund management and passive fund management. Instead, the competition is between active management by a fund manager and active management by an index committee or an algorithm filtered through an index committee.

I predict that for quite some time to come, most fund managers will win.

The writer is CEO, Value Research India Pvt Ltd