"Index funds that are very low-cost, are investor-friendly by definition and are the best selection for most of those who wish to own equities."

—Warren Buffett

The master investor is a fan of passive management. He says that reputable index funds like exchange traded funds (ETFs) have much in common with his investment firm Berkshire Hathaway. For one, both manage investor assets with integrity at low cost. Though advocates of active management use him as an example that this practice is necessary, Buffett preaches the opposite.

He reputedly told Bill Gates to put much of his non-Microsoft holdings into index funds. Which begs the questions: should retail investors invest in index funds or ETFs? Yes. What are your chances of finding mutual fund managers who can keep beating the index? Slim to none.

Keep it boring, simple, cheap: Invest in passive management; invest in index funds and ETFs. An index fund is designed to do no better or worse than the benchmark it tracks. Passive investing is consistent, low cost and transparent. It eliminates individual bias of an active fund manager. It assumes that markets are efficient and all information available is discounted in price.

For instance, the Nifty BeES, an index fund tied to the Nifty, holds all 50 Nifty stocks in it. Now, it’s easy to index your way through asset classes, including mid-cap stocks, sectors (Bank BeES), bonds, commodities (Gold BeES) and global markets. If you prefer index funds with a bias toward a value or growth approach, in future you might find those too.

The big complain against index funds is that they’re average: But, ironically, investors who settle for average market performance usually end up richer than investors who stick with portfolio cowboys who aim for shoot-out-the-lights returns. The psychic energy of an active fund manager is spent analysing companies, dumping or acquiring crores of rupees worth of stocks or bonds with a few mouse clicks and deciphering the cryptic remarks of the finance minister, the RBI governor or the corporate honcho.

Index believers look at this frenetic hustling and think, “What’s the point?” They appreciate that some active fund managers can beat a benchmark for a year or three. But they also understand that on the long path to sustained excellence, almost all climbers drop out. There is a reason why Buffett is so celebrated. He believes in indexing.

Some funds have spanked their indices over the past few years (this is not strictly true as they benchmark themselves against the wrong indices). But that won’t help us going forward. Performance means nothing when you’re trying to guess who will be selected the fund manager in 2017 for being the decade’s best manager. It’s better to stick with index funds, a sure thing.

Because index funds are so alluring, more and more investors will discover them. So will the financial industry. But you, the retail investor, should be there early.

Sanjiv Shah, Executive Director, Benchmark AMC