Although index mutual funds have been in existence since the beginning of the mutual fund industry in India, of late, they are gaining more traction. The recent performance of the index funds as against their actively managed counterparts has brought them into the limelight.

Over the last 1 year, while the average return of index fund category has been about 3 percent, the average return of a large-cap fund has been about negative 3 percent. Even the 3-year return from the index fund category looks better than the large cap funds. “If you look closely at the returns of Nifty Index fund in comparison with any professionally managed fund, you would see it has outperformed them in many ways,” says Rachit Chawla, Founder & CEO, Finway.

Why have the index funds suddenly gained importance

Today, it seems the index funds are gaining ground and rising in popularity. Two important developments in the mutual fund’s industry have turned the tables in favour of the index mutual funds.

One, post the re-categorisation exercise in 2018, the funds have to stick to their allocation mandate. It means, a large cap fund is not allowed to sway into the mid-cap territory to generate alpha and vice versa.

Secondly, the benchmarking of the funds will now have to be against the total return index (TRI) and thereby include dividends ( received by fund house from invested companies) while comparing performance. These two developments are considered important that may have led to the emergence of the index funds generating a higher return than other actively managed funds.

Why index fund generates return in-line with market

Index funds are a sort of proxy to the market. Simply, put, if the market (the index) generates 16 percent annualised return over 16 years, the index fund will more or less generate an equal return. Now, over the same period, an actively managed fund could have generated 22 percent, while another actively managed fund could have delivered 7 percent.

However, being an index fund investor, one can safely assume to get the returns in line with the market. How? This is because the index portfolio will exactly mirror a broad-based index like the Sensex or the Nifty, both in composition and weightage.

What’s a tracking error

If the Sensex rises or falls 25 per cent in two years, an index fund linked to the Sensex will show an identical rise, barring a ‘minor tracking error.’ This tracking error arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unit holders. So, if the Sensex appreciates 12 per cent during a particular period while an index fund mirroring the Sensex rises 11 per cent, the fund is said to have a tracking error of 1 per cent.

How they differ from other funds

Index funds are passive funds where there is no role of the fund manager in the selection of stocks. On the other side of the prism is the actively managed fund, where the role of the fund manager is crucial in the fund’s performance. Fund managers take active calls in the selection of stocks within each sector and actively manage the portfolio with the aim of beating the fund’s benchmark.

Such an approach has its own drawback – the fund manager’s call may not work and the fund doesn’t perform well. No wonder, several active funds fail to beat their benchmark. However, such phase of low performance may be for a short to medium term period and over the long term, established fund houses and fund managers with a good track record have shown consistent long term performance.

Whom they suit

For a new mutual fund investor, an index fund can be a nice starting point. It helps one to get familiar with the ups and downs of the markets and over time may consider other actively managed funds. Chawla adds, “An index fund is the best option for people who are not aware of that how equity market works. Anyone who is new to investment should buy an index fund and think passively on it.”

What to do

Maybe, the time has come to give large-cap funds a pass even by the seasoned investors. The returns from an actively managed large-cap fund will depend largely on the fund manager’s call and therefore may either outperform the index or fall back. An index fund, also constituting large-cap stocks will, however, deliver returns in line with the market. If at all an investor need the fund manager’s acumen to work in his or her favour, opting for mid-cap fund along with the index fund could prove adequate.