Is it Actively Managed Mutual Funds or Passively Managed Index Funds that come out on top?
Over the past decade, index funds in India have demonstrated strong growth and offer distinct advantages over actively managed mutual funds. This shift in preference is becoming increasingly apparent, especially since 2018.
Performance
Index funds, which track broad indices such as the Nifty 500, have shown consistent long-term returns aligned with India's economic growth. These returns often approximate the market average, delivering returns around 15-20% annually over the long term. On the other hand, actively managed funds can outperform or underperform index funds, with their performance depending on the fund manager’s skill.
Risk
Index funds, with their broad diversification across market sectors and capitalization segments, inherently offer lower risk. This reduces sector-specific volatility, allowing for steadier compounding. In contrast, actively managed funds may carry higher risk due to concentrated bets on certain stocks or sectors, which can result in larger deviations from market averages.
Advantages
Index funds offer lower expense ratios, broad market exposure, transparency, and are suitable for long-term investors, beginners, and those preferring low-cost, diversified, and systematic investments. Actively managed funds, while offering the potential for outperforming the market, have higher expense ratios, can be concentrated, and are less transparent.
Contextual Summary
The passive funds market in India has seen explosive growth, especially since 2020, reflecting growing investor preference for low-cost, market-matching returns. Indian equity markets over the past decade have rewarded consistent, long-term investing. Index funds like those tracking Nifty 500 provide diversified exposure to India's top companies across various sectors, making them ideal for systematic investment plans (SIPs) and long-term wealth creation.
However, it's important to note that actively managed funds may still be appealing for investors willing to accept higher fees and risk for the chance of outperforming the market, but such outperformance is not guaranteed and past returns may not be indicative of future results.
In a portfolio of mutual funds, the risk that needs to be discussed is the selection risk. This is the possibility that one fund underperforms the index while another overperforms, meaning the underperforming fund's losses need to be compensated by the overperforming fund.
Over the last few years, slightly more than 50% of the actively managed large-cap funds have struggled to keep up with a NIFTY 50 index fund. This underscores the importance of understanding and managing selection risk in a portfolio.
In conclusion, index funds in India have grown strongly over the past decade due to their low cost, diversification, and stable market-mirroring returns. Actively managed funds carry higher risk and cost but occasionally offer higher growth potential. The choice depends on investor risk tolerance, cost sensitivity, and preference for active versus passive management.
Globally, index funds have captured a larger share of the wallet as compared to active funds. And there is a growing case for that happening in India too over the next decade.
Investing in mutual funds can be a strategic move in personal-finance, with index funds being a popular choice. Index funds, like those tracking Nifty 500, offer distinct advantages such as low expense ratios, broad market exposure, and transparency, making them suitable for long-term investors, beginners, and those seeking low-cost, diversified, and systematic investments. On the other hand, actively managed funds may carry a higher risk due to their potential for higher fees, concentrated bets, and less transparency.
