“An index fund is the most sensible equity investment for the general investors. By periodically and regularly investing in an index fund, even a know-nothing investor can outperform a seasoned investment professional.”
Take it from investing legend Warren Buffet, who absolutely swears by these funds. And for good reasons. A recent study conducted by Kotak Institutional Equities noted that over a three-year and five-year time period, 60% of funds underperformed in comparison to their benchmark index.
Globally too, most mutual funds are unable to buck this trend. As per S&P Dow Jones Indices 2021 annual SPIVA report, 80% of all actively managed US mutual funds fell short of their benchmark index.
Unsurprisingly, around 40% of all mutual fund assets in the US are held in passive funds. But why does this matter?
Active vs passive
An actively managed mutual fund has two distinctive elements. The first is a professional, namely the manager who dynamically manages assets, attempting to make the most of the market conditions. Consequently, its investors are charged a percentage of the total assets under management (AUM) for funding such administrative expenses. Usually, this comes to around 0.5-2.5% of the AUM.
Passive funds, on the other hand, do not need regular management. The idea is to simply replicate the benchmark index. They’re in essence, the reflection of the market, down to the last trade.
For instance, the banking and finance sector has a 31.89% weightage in BSE Sensex. So, any index fund that tracks this 30-strong index will also allot the exact proportion to this sector. Since this does not require any specific expertise, the total expenses, as a percentage of the AUM, do not generally cross 1%.
By virtue of cost-effectiveness and ease of entry, new investors are thronging to passive funds. According to recent data from the Association of Mutual Funds of India (AMFI), July 2022 saw inflows worth Rs 6,770.23 crore in 95 index schemes. Even during Q1 2022, these funds saw investments of about Rs 19,086.27 crore.
Says veteran mutual fund analyst and editor of investment magazine Nivesh Manthan Rajeev Ranjan Jha, “Index funds are the ideal stepping stone for new investors because index funds do a great job at delivering returns at less cost. Any index excludes underperformer securities and includes only those that will qualify well on certain performance parameters. Add to that the diversification it provides, and index funds should always be a part of the portfolio.”
Don’t completely discount active funds
But caution! It is also not financially prudent to completely exclude active funds from your portfolio. The same research by Kotak also showed that over a 10-year period, 80% of actively managed AUM outperform their corresponding benchmarks.
Financial planner Sanjeev Davar bats for a mixed, balanced approach. “Passive investing has certainly gained popularity over the past few years, in comparison to investment in actively managed funds. Easy access to information has attracted more retail investors to this space.”
“A combination of active and passive funds will always be a prudent approach, rather than siding with just active or passive funds. An actively managed fund always helps in avoiding mistakes and safe steering during difficult times,” he signs off.
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