Are index funds better than active mutual funds?

Index funds are popular in developed markets such as the US and UK as compared to emerging countries like India. Due to re-categorization in mutual funds schemes, investors have made a gradual shift from the active mutual funds to less-known index funds. The fund managers have to follow the mandate given by SEBI and will play with the defined boundaries. Still, the fund managers will try to select stocks which beat the benchmark, but the outperformance will be less as compared in the past.

One cannot compare efficient markets like the US, where many investors are inclined towards index funds versus the Indian market. Also, the Indian market is yet to achieve the scale and capitalization, which is much lesser as compared to the developed markets.

Index fund generates return in-line with the market
Having said that, many conservative investors who were investing in large-cap funds, earlier, have moved to index funds to reap the benefits of volatility in the market and lower expense ratio. Some analysts do believe that actively managed funds will give better returns like in the past, and the flexibility that the fund manager enjoys to choose funds that can outperform the index. The index funds mirror the given index, returns will be inclined to rise or fall of the index. Some of the active mutual funds do have lower expense ratio, which puts them in a level playing field as compared to index funds.

In the present situation, index funds have outperformed or taken less hit than the large-cap, mid-cap or small-cap funds. Although large-cap funds will find it difficult to beat the benchmark, one should not invest in mutual funds, which have not been a consistent performer in the past 3 or 5 years. Large-cap mutual funds should be selected wisely, and if the investor has a conservative profile, then the index funds are the best to invest in via Systematic Investment plan (SIPs).

Tracking Error of Index funds

If the Sensex falls or rise by more than 25%, the index funds will mirror the performance of the Sensex, barring a minor error. This error is related to an expense charged by the fund as management charges, marketing expenses, fees, etc. The index funds will give less returns of 1%-2% as compared to Sensex, which is also called as tracking error.

Difference between Index and other funds
Index funds are passive funds, wherein the fund manager plays no role in selection of stocks. On the other hand, the fund manager selects the stocks, which can beat the benchmark, and crucial for the fund’s performance. However, there have been times wherein the fund manager has selected incorrect stocks, which dampens the performance of the mutual fund. Such phase may be short-to-medium-term as many established fund managers select stocks, which have beaten the benchmark.

Low expenses make index funds attractive

The falling expense ratio of the index funds have made them attractive. As per the below table, the expense ratio ranges from 20 bps to 30 bps. For direct plans, it is much lower.

For new investors, index funds are the best to invest as it helps them to get familiar with ups and downs of the market and make them more aware of the shifts in equity market. Also, the time has come to give up the large-cap mutual funds as the fund manager can invest within the boundary line, thus affecting the performance of the fund i.e. outperform or fall back. At least, the index funds having large-cap stocks too can mirror the performance of the index and generate better returns in line with the market.

An index fund buys and holds all the underlying stocks of a particular index, in the same proportion, thereby becoming a passive investment vehicle. As such, since there is no active fund management or additional research and analysis, these funds have low expense ratios. But there are as many index funds as there are mutual fund companies and indices.

For US and developed markets, the expense ratio for index funds are really low. Moreover, their market is also a little efficient and hence, American investors prefer index funds.

However, for the Indian market, the charges for index funds are comparative higher. Moreover, here the fund managers still have a lot of opportunity to pick right growth companies as India is the fastest developing economy. Given you pick a fund after proper research that has a right fund manager, active funds are better than index funds in India.

Choosing your index fund. These funds may follow a market-cap weighted broad market index or equal-weighted market index. Others may be tracking a particular sector weighted index. It is important to understand the index construction methodology so as to be able to match it correctly to your portfolio. Thus, while their low cost attracts many investors into index fund investing, it pays also pays to follow these steps in order to successfully pick a winning fund suitable for your portfolio.