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Advantages and disadvantages of index funds

ET Online|
Last Updated: May 21, 2020, 10.24 AM IST

Summary It is true that many actively-managed large cap schemes struggled in the last two years, whereas their passively-managed counterparts topped the return charts.

ET Online
Many mutual fund investors are slowly becoming fans of passive investment strategy. The performance of passively-managed large cap index funds in the last two years seem to have convinced many investors about the invincibility of the passive strategy in India. Many investors in developed countries prefer index-based low cost funds as they are convinced that it is difficult to beat the market consistently over a long period.

It is true that many actively-managed large cap schemes struggled in the last two years, whereas their passively-managed counterparts topped the return charts. However, mutual fund managers and advisors point out that the performance is because of the narrow rally we have witnessed in the stock market. Flush with liquidity, many investors were chasing a few select stocks in the index. This helped index schemes and a few schemes that held these stocks. However, passive funds should continue with the superior performance for a few more years before one can build a case for them, say advisors.

These advisors point out that several actively-managed funds, especially in the multi cap, mid cap and small cap segments, continue to beat their benchmark by a wide margin. They believe that many funds would be able to generate alpha or make more returns their benchmark in India at least for a decade. This got nothing to do with supernatural ability of fund managers, but it is the nature of a developing market like India where there are several under-researched and relatively-unknown stocks that are discovered every year, they say.

As you can see, one thing is very clear: it is only a matter of time when passive funds would become the preferred vehicle for regular investors. Let see what are the advantages of passive investment strategy? In other words, what are the pluses of index funds? One, you don't have to worry about the performance of the fund manager in these schemes. All you are looking for is to do as good or bad as the index. As you know, an index fund invests in the same set of stocks in the same weightage they have in an index. This means the scheme would move up or down in tandem with the index.

Sure, there could be a small difference. That is called the tracking error in investment parlance. So, you should always look for an index fund with the lowest tracking error.

The second advantage of index funds is the expenses incurred by these funds. That is why passive investing is called low-cost investing. A low cost index fund allows you to benefit from the stock market in the most efficient manner. Actively-managed funds mostly have higher expenses because the fund manager may be trying to buy and sell stocks based on his or her outlook.

Do they have any disadvantages? Well, you let go of an opportunity to earn extra returns every year. If the claims of fund managers about the ability of developing markets to offer alpha is right, then it means you would be losing some returns every year. Over a long period, this could be quite sizable.

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