Warren Buffett, arguably one of the greatest investors of all time, made a $1 million wager in 2007 that no hedge fund could beat the index over a period of 10 years. Buffett believed that even if active management could manage to generate higher returns in select years, they fail to outperform the market in the long run. Long story short, Buffett, won his million dollars in 2017 and donated the money to a charity.

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Buffett has been a strong proponent of passive investing, and their merits over active investing. The debate of active vs passive investing is an ongoing one. This article adds to the discussion.

Passive funds, or Index Funds, invest in a group of securities that replicate the index. The purpose of index funds is not to beat the market, but to provide the same returns as the market.

Fact: When we say ‘market’, we refer to the market index, which is a collection of stocks meant to represent the whole of the market. The popular indices in India are Nifty 50, Nifty Nest 50 and Sensex.

Active funds, on the other hand, are managed by fund managers who try to outperform the market using their investment philosophy and expertise. The funds have higher fees compared to index funds, due to the hands-on management of the portfolio.

Why Index Funds?

Lower Fees: The expense ratio of Active funds range between 1% to 2.5%, while index funds charge as low as 0.12% (UTI Nifty Index fund). Periodic outperformance is generally not worth the higher fees that’s paid out even in times of downturn.

Lower Risk: Active funds are much riskier than Index funds as they employ hands-on portfolio management in an attempt to outperform the market. Active funds have the freedom to buy any security that they think would generate high returns, which is great when the portfolio managers are right but terrible when they're wrong.

Market Performance: Index funds give more or less the same returns as the overall market. Index funds gave an average of 13.7% returns as compared to 10.2% by large cap funds, 8.22% by multi-cap funds and 4.8% by mid-cap funds in the past year.

Transparent Portfolio: Index funds invest in stocks that are in the market indices (be it Nifty50, Nifty next 50, Sensex, etc.). So you know where your money is invested, which makes it easier to track.

The Final Word

Indian investors are slowly, but steadily, shifting to Index funds. The lower fees have been a major incentive for investors who don’t have to incur high costs for their mutual fund returns. With the recent change in SEBI norms, active funds are more likely to underperform, as the stricter definition of large-cap stocks has limited fund managers’ ability to change styles for better returns.

The question that’s being asked more and more is, “why pay higher fees for actively managed funds when they don’t outperform the Index?”

Maybe it’s time you asked the same.

Niveditha Vishwamithra is an Analyst at Kuvera.in: India’s first completely free Direct Mutual Fund investing platform

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