Mutual Fund Investment: Do Index Funds Deserve A Place In Your Portfolio?

Sometimes, in life, we face questions that have been debated across the globe for ages: Rent or buy a home? Do it yourself or hire a professional? Cook at home or eat out? Choose freedom or structure? Embrace innovation or stick to tradition?

Index Funds vs. Active Funds has been another enduring debate, dating back to the launch of the first index fund by Vanguard in 1976. Index funds or passive funds are a type of mutual fund or exchange-traded fund that aim to replicate/track the performance of a benchmark index.

For example, Nifty 50 index fund will replicate the performance of the Nifty 50 index. It will do so by holding the 50 securities that comprise the Nifty 50 index in the same proportion as their weight in the index.

“Index funds do not require any research or active stock selection. They simply buy and hold securities replicating the index. This makes them efficient and lowers their costs, making them a cost-effective investment as compared to active funds,” says Sanjay Chawla, Chief Investment Officer – Equity, Baroda BNP Paribas Asset Management India Private Limited.

“However, index funds do not outperform the market, and their efficiency may be affected by how closely they replicate the index and how effectively they minimize their tracking difference and tracking error,” he adds.

Active funds, on the other hand, rely on detailed research and the skill of their fund manager to deliver returns that beat underlying benchmark index. An active fund may be constantly looking at various market opportunities and will churn their portfolio. This may lead to higher costs and thus higher expenses. There is also a risk of the active fund underperforming their benchmark for periods of time.

Active Funds vs Index Funds

So, does this mean that active funds are bad and index funds are good? Should we only invest in index funds?

“Not necessarily. The universe abhors any imbalance. Nature always seeks a balance and markets are no different. Investing only in market cap index funds at the cost of active funds leads to money flowing in the top 100-150 companies that hold majority of the weight in the index. Those companies get consistently overvalued and the remaining companies are ignored leading to pockets of undervaluation,” informs Chawla.

This is where active funds come in to correct the balance. They strive to find these pockets of undervaluation and aim to correct the same, delivering benchmark beating returns in the process. Markets will always seek a balance and as an investor, it is imperative that your portfolio does the same.

One way to achieve that balance is a core satellite portfolio strategy. The portfolio when plotted on a diagram will appear like a planet and its moons, hence the name core satellite.

Factor funds (Active & Passive) can also form a portion of their satellite, for example, a momentum fund, a quality fund etc.

Do Index Funds Deserve A Place In Your Portfolio?

"The answer should be yes. The above approach is just one of the approaches that can be used to incorporate index funds in your portfolio. Index funds are efficient and cost-effective investments that deliver benchmark returns, keeping you in sync with the markets," says Chawla.

In contrast, active funds help you deliver returns that have the potential to beat the market based on performance. A balance of both might benefit an investor's portfolio much more than only index funds or active funds.