Business Today

Index funds vs active funds

With major indices taking a breather, should you make the switch to actively managed funds?

Clifford Alvares        Print Edition: September 20, 2009

With their low expense charges and large cap market exposure, index funds mirror the economy's performance really well. Market experts often recommend index funds to investors who want to take a first-time exposure to the stock market. As these funds invest and hold the same stocks as, say, the Sensex, in a similar proportion as it is calculated in the index, they are fairly standard products.

Their objective is not to beat or outperform the index, but to follow them. By contrast, an active fund tries to beat the benchmark it follows. Now, as stock market indices have shifted from rapid acceleration to a neutral gear, the big question is: should you switch out of the vanilla index funds and into actively managed funds?

As the stock markets are in a consolidation mode now, active funds are likely to outperform the indices. In the last six months, actively managed funds returned 76.5 per cent on average, while index funds returned 65.9 per cent. Says Hemant Rustagi, CEO, Wiseinvest Advisors: "There's a whole universe of stocks outside the indices, and investors should participate in their growth."

However, if you have a 10-15 year horizon, chances are that index funds will beat the actively managed funds by some distance due to the lower fee structure. Besides, it gets increasingly difficult to beat the market on a regular basis year after year for a long period of time. Also, for investors who have just begun their investing journey and who believe in the India story, there's no denying that index funds are the best way to start.

An index portfolio is made up of strong large-cap blue chip companies and funds with a lower tracking error are generally better placed. Says Viraj Ghatlia, VP Strategic Solutions, ASK Wealth Advisors: "Over long periods of time, index funds do well. It takes the risk out of active fund investing and is ideal for investors in the long run as part of your asset allocation."

But the advantage of sticking to an index fund may provide low comfort, particularly, with the frontline indices having surged 92 per cent since March 5 this year. Index funds work only in the initial stages of a rally. And as the rally progresses, stocks outside the index begin to rise.

On the other hand, the Indian stock markets lack depth of volumes and players, which provide a lot of leg room for fund managers to actively pick stocks. Says Sandesh Kirkire, CEO Kotak Mutual Fund: "As markets have gone through an entire lifecycle, it becomes difficult to beat the indices and that's where passively managed funds do well. In India, there are many opportunities as private equity is nascent, capital markets are growing, so it offers a good platform for fund managers to do well."

But investors switching from index funds should not enter into aggressive mid- and small-cap funds, but instead look at diversified funds with a healthy large cap exposure and some mid- and small-cap stocks. Says Rustagi: "Otherwise, it will alter your risk profile."

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