Index Investing in a Nutshell

 So, finally, I have been able to come up with a single answer to the answer I spent a long time on.

Honestly, it wasn't that difficult of a problem, and It is strange why it took me so long to reach the final conclusion. It was because I keep hopping in and out of certain topics I'm thinking about, and this one got completely knocked of my mind unless I was reminded of about it when the indices dropped because of the tensions arose between India and Pakistan.

So, the idea is simple. Savings are good. But value of money decreases over time because of inflation, so it is a good idea to not hold liquid money, rather invest it somewhere. Some people prefer to lend this money instead of investing it, which is, they would either deposit the money in a saving account which would earn interest which will help the money not lose its value, or they will lend it to some other entity like government, in the form of buying a government security such as T-bill or Savings Certificate (. Interestingly, in Pakistan's case, even what people deposit into bank, around 70% of that indirectly is a lending to the government because it is the biggest borrower from banks). Some people use the term investing for this as well, but I would suggest not to use this word because it confuses with the economic concept of investing which is different.

Investing means buying a stake in the business and getting the right to earn a proportion of the same reward as does the business, while lending is just buying the interest you would get back according to the terms. Both have risks. If the business, you have bought a stake in doesn't earn a profit, neither do you. On the other hand, if your borrower goes default, you lose all or some of the money you have lent. But generally, it is assumed that the probability of the lenders (banks/governments/businesses) going default is less than the businesses earning a loss. One may or may not agree with this assumption, but I think I'm going astray from what I originally intended to write, and I should maybe write about economics of it at some point later.

So, I prefer buying stakes at a business rather than just lending my savings to the banks which in turn might lend it to government or to businesses or to consumers (e.g. people financing cars/homes). For people, who don't have a significantly large amount of savings, the way to do this is to buy shares of companies that they think will remain profitable for years to come.

But, the thing is, how will you know which listed (the shares of which are traded on the stock exchange they are listed in) companies are a good business and which one's aren't? It turns out, finding that out is full-time profession of a lot of people. But if you don't want to spend a lot of time deciding which stocks to buy yourself, there's a simpler way -- buy a very diverse basket of shares of companies which are doing well in the stock market. But actually not buy all those shares yourself, but buy only shares of that basket. Those baskets are called indices and the shares of those baskets are called Index Funds or Index ETFs. Different indices (basket/collections of shares with different weightage) are defined by different companies, and they all have different criteria. So what you have to do is to select an index that covers a large no. of diverse companies that are persistently doing well in the stock market, and buy an index fund or ETF for that index. The company that decides the index will every once in a while make changes to the constituent stocks of the index and their weightage, and the index fund managers or ETF managers would update their holdings accordingly.

The, interesting thing is, that if you do this, across a time-horizon spanning years, you will earn higher returns on your investment even those full-time professionals. It is important to note that investment is made on time horizon usually spanning years. Some people buy and sell shares and other assets, on a day-to-day basis. That is called day-trading and is totally different than investment, and is somewhat similar to gambling because a big proportion of short-run fluctuations of these assets are not from the mechanism which results in its long term changes, but rather these short-term fluctuations come from perceptions of these day-traders about the difference between current and few-hours-future perceptions about a particular stock by other day-traders. And over a significant number of attempts, the expected-value of the no. of getting this perception of perception right (+ve) and wrong(-ve), is zero at best and negative at worst (for small players because large players have the power to sometimes manipulate the market). But this can occur only in time horizon of hours and days. Across months and years, the only thing that determines the value of a stock is how good that company is doing and is expected to do the business.

This entry is becoming entangled with no central point, so let me return to idea of what's the best approach for a NON-financial-expert with small savings.

I was talking about index fund. And yes, this has been historically proven, index funds on a longer time horizon have earned higher returns than majority of the professional stock-pickers. In US, the most popular index for this is S&P500, also recommended by an expert well reputed in this field -- Warren Buffet.

So what, I was looking for was what's the S&P500 alternative for PSX?

S&P500 includes 500 companies from around total of 6000+ companies from US's two major stock exchanges -- around 7%. In Pakistan, there's only one stock exchange PSX which lists 500+ companies, 7% of which makes around 35 companies. The principle of diversification requires you to have a higher no. of stocks in your portfolio (Portfolio is simply the basket of shares you have personally bought (and other assets). But on the other hand, if S&P500, includes only 7% of the companies, that is because those 7% stocks are those that make up around 80% of the total value of all shares of all stocks traded in the exchange (market capitalization of exchange). So, the ideal equivalent would be KSE-100 index of PSX which includes 100 companies that represent around 85% of PSX's market cap. Even though KSE-100 is the most widely used index for representing the stock exchange, there is no ETF available that tracks KSE-100 (I have yet to find out why).

In Pakistan, there are not index funds, but there are 9 index ETFs that also are traded on Stock Exchange. So, my task was to find out which one is best among these ETFs.

1. ACIETF - Alfalah Consumer Index ETF
2. HBLTETF - HBL Total Treasury ETF
3. JSGBETF - JS Global Banking Sector ETF
4. JSMFETF - JS Momentum Factor ETF - 10 only
5. MIIETF - Mahaana Islamic Index ETF - 30 companies
6. MZNPETF - Meezan Pakistan ETF - 12 only
7. NBPGETF - NBP Pakistan Growth ETF - 15 only
8. UBLPETF - UBLPakistan Enterprise ETF - 9 companies
9. NITGETF - NIT Pakistan Gateway ETF - 14 companies

For me, this was a rather simpler decision between MIIETF and MZNPETF - the two ETFs which only track stocks of those companies that fulfill Shariah-compliance criteria, the prominent result of which is that conventional banks are excluded, which is a good thing because Pakistani banks are making most of their profit by lending to government, and if I wanted to earn through lending, it would have been much simpler to just buy government issued Treasury Bills or Savings Certificate instead of purchasing stocks of banks which are indirectly earning profit by lending to the government. The banks in principle will never have a return significantly higher than the interest rate government is offering on its securities. However, I will apply my criteria to all of the ETFs.

The basic criteria is:

• Diversification
• Methodology
• Total Expense Ratio (Management Fees)

1. Diversification

HBLTETF, ACIETF, and JSGBETF are instantly out because they only target a specific sector. Then, we have to see number of stocks included in the index. Small number of companies means less diversification. Interestingly, the maximum number of stocks covered by the remaining is 30 by MIIETF which is followed by NBPGETF covering 15 and NITGETF covering 14. Interestingly, NIT Index tracked by NITGETF does not have a limit on maximum number of stocks rather it includes as many high market-cap-stocks that make up 50% of PSX's total market cap. Keep in mind S&P500 covers stocks making up around 80% of market cap. So, anything less than 50% is obviously out of question. Thus, we have only 3 candidates by this point. Among these, MIIETF is the best candidate from diversification perspective:

2. Methodology

An interesting thing I just found out is that NITGETF does not cover 50% of exchange's total free--float market cap, but rather 50% of KSE-100's free-float market cap, which means 50% of 85%, i.e. 42%.

Anyways, all three of these indices use free-float market capitalization methodology.

MIIETF includes top 30 stocks among all Shariah-compliant stocks. Upon checking, I found out, that apart from stocks of banks, only 3 stocks from KSE-30 index were excluded from MIIETF. DFML was excluded because it had debt-to-asset ratio of 133% while compliance requirement is <37%. POL and FFC were excluded because they did not meet the criteria of non-compliant income and non-compliant investment to assets ratio. POL belong to Oil Sector and MIIETF has substitutes for that, and for FFC, a fertilizer company, it doesn't matter because the two other ETFs are not including even a single stock from fertilizer sector, while MIIETF has other stocks from fertilizer sector.

MIIETF and NITGETF include weightage purely based on market capitalization while NBPGETF has 50% weightage from market cap and 50% from daily traded value with weightage capped between 3% and 10%.

NITGETF and NBPGETF have stricter and complex liquidity requirements while MIIETF has a single straightforward requirement of average daily traded value of PKR 10 million over the last 12 months.

MIIETF is recomposed quarterly while others are re-composed semi-annually.

3. Total Expense Ratio (TER)

The declared management fees are:

• MIIETF: Up to 0.70% p.a. of the net assets of the fund
• NBPGETF: Up to 0.75% of the net assets per annum
• NITGETF: 0.40% of the net asset per annum

But let us check their exact latest expense ratios from their April 25 fund manager reports.

	Management Fees	TER (YTD) including levy
MIIETF	0.5%	1.07%
NBPGETF	WEBSITE DOWN
NITGETF	0.4%	1.18%

Here, again MIIETF is the winner because of lower total expense ratio.

At this point, it was clear to me, that MIIETF is the right ETF to put your savings in. If suppose, MIIETF was not there, then my choice would have been NBPGETF (though I would have first confirmed its TER).

But you know what's the ideal situation. Ideal situation is to buy an index that is actually an index of one index from different countries of the world. An index of indices would be the ideal diversification. But for now, I don't want to get into the hassle of how to buy foreign ETFs reliably (because investing is meant to be where you save your savings and thus, your funds would be at the place for who knows 5, 10, 15 years) and I haven't found out a reliable way yet (which also doesn't cost a large amount of fees).

I had thought about I would end with some basic things such as, the purpose of such investing is not to complement or replace your income, it is to preserve savings along with accumulating some wealth. Young people should realize that the highest ROI is on human capital. I know some young guys who waste a lot of time on this stuff trying to make income from there, without realizing how greater return they could have earned if they had invested same amount of time on themselves. This is something you are supposed to think about only once to devise your strategy, and then just run on that strategy for the next 20 years on auto pilot, and think about things that matter more.