Passive Funds – Fixed Deposit of Equity Market

Generally, the discussion of investment starts with Fixed Deposits (FDs). Most of the investors are happy investing in FDs because of very low volatility,assumed less risk and fix rate of return which is know at the time of investment. But are FDs really risk free? Absolutely NO. FDs has inflation risk i.e. FD rates will not be able to cope up with inflation. So actually in real term, FDs gives negative returns. However, investors still prefers FDs over most of other investment only because of single reason – low volatility or One may say no volatility.

What if there is an instrument which gives investor returns which will at least beat the inflation in long run, with bearable volatility.

Passive Funds, i.e. Index Funds and ETFs are such instruments which gives investor exposure to Equity as an asset class. In long term equity as an asset class by pure mathematics will beat the inflation. Let’s see how?

Suppose investor create the FD with a bank for 10 years at 7% per annum. To pay this 7% annually, bank has to lend it at higher return. Let us assume bank lend it at 10% per annum to a corporate. Now that corporate to pay this 10% annually on loan taken from bank, has to efficiently deploy this funds it in its business. Corporates has to earn at least 14% to 15% on this fund to appropriately justify to its owners. Thus, the funds which are kept at 7% of annual interest are finding its way to annual yield 15% or above i.e. double of what it has roots to.

In such case, if investors has “X” faith in FDs, ideally should have “2X” faith in equities. No doubt, equities are more volatile then FDs. But that additional risk investors are taking will be awarded with appropriate returns in long run.

Some mathematics

From 1980 to 2016 i.e. period of 36 years average one year FD rate is around 8%. In 1994-1995, FD rates went up to 13% per annum & in 2003-2004 wend down to 5%. Currently one year FD rate is around 7%. Standard deviation i.e. measure of volatility of FD rates are 2%

Now let us look at similar data for S&P BSE Sensex.

In 1979 S&P BSE Sensex was 125 points which is currently around 29,000 points. If we consider dividend & bonus etc. which is captured in Total Return Index (TRI), current S&P BSE Sensex value is around 40,000 points.

If we consider, 30 years of monthly rolling returns, on an average S&P BSE Sensex has delivered 16% return with standard deviation of 1%.

Thus, by investing in Passive Fund (Index Fund or ETF) which is linked to S&P BSE Sensex with a volatility of FD i.e. 1% one may expect returns of around 15%-16%. Isn’t it FIX DEPOSIT of EQUITY MARKET?

Happy Indexing:)

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Disclaimer: This post is only for information and should NOT be considered as investment advise. Investor should do due diligence before investing.