Let us first start off by understanding what passive investing is all about and what is the logic behind it. You first need to understand the difference between active and passive investing. Imagine the fund manager of a diversified equity fund. This is an example of an active fund manager. The fund manager has to take a call on which stocks to buy, which stocks to hold for the long term, which stocks to trade for the short term and which stocks to sell. The fund manager of an active fund not only looks at the stocks per se, but also looks at how these stocks add up as a portfolio. A diversified equity fund must have a portfolio that is diversified in terms of sectoral and thematic exposures. In short, the active fund manager is a busy man and is constantly on his toes. That is where the challenge comes and an index can solve most of these problems.

The passive fund manager, on the other hand, focuses more on just tracking an index. To begin with, the fund manager will create a portfolio of stocks that will mirror the index (Nifty or Sensex) in exactly the same proportion. The fund manager does not have to use any discretion on stock selection. When the index components change, the fund manager also modifies the portfolio along with the index? The job of the passive fund manager is a lot simpler. But you may wonder; does it really make sense to invest in index funds? Don’t you pay the fees for the fund manager to give you higher returns? That brings us to the basic question; should I invest in index funds? Are index funds safe and what are the advantages and disadvantages of index funds? You need to understand two important things about index funds before going into the specific pointers. Firstly, the index is hard to beat consistently and that is evident if you look at the market performance in the last few years. Post 2014, most equity funds have struggled to beat the index as markets become more homogenous. Here is what you need to know about index funds.

These index funds are the ultimate example of passive investing. Since the index fund is just pegged to the index constituents, its portfolio mix becomes a lot simpler and also a lot more predictable. Having said that, index funds can generate healthy returns over a longer time horizon provided one has the patience to hold on with discipline. The Sensex has a base value of 100 in 1979 and over the last 39 years it has given 36-fold returns. The NSE Nifty index has its base in the year 1995 and has given 11-fold returns over the last 23 years. What it means is that even an index fund on the Nifty or Sensex would have made good returns over the last many years.

In an index fund, the risks become more finite and transparent in case of index funds. The Nifty and Sensex are already well tracked and taking a macro view based on historical data is much easier compared to specific stocks. The universe is easier to track and estimate. What is the reason? The reason is that index funds are purely about beta. Alpha is the big challenge for equity diversified funds where they are under constant pressure and hence are forced to take on more risk in their books. The index fund manager has no such requirement. He is only required to take on market risk in the form of Beta. So no negative surprises for investors!

It is also about bias and costs. A big advantage of Index funds is that they overcome human bias in a big way. The problem with diversified equity funds is the strong element of discretion given to fund managers. As a result, the fund manager’s conditioning, biases and past experiences make a difference to the investment strategy of the fund. The index fund, being a passive fund, just tracks the index. Costs in an index fund are much lower. In the last AGM of Berkshire Hathaway, Warren Buffett had lauded the efforts of John Bogle, the founder of Vanguard Funds. It may be recollected that Vanguard is one of the world’s largest asset managers with over $4.30 trillion in AUM. Buffett pointed out that Vanguard had saved billions of dollars in costs to mutual fund investors by adopting an index based strategy.

If you are not Warren Buffet then you are an index fund, is a common joke in markets. When active investors like Warren Buffett commend index funds, it is surely affirmation of the rising importance of index funds as an asset class. It is yet to take off in a big way in India as funds are able to earn higher returns using an active strategy. But at these kinds of alpha plateaus, the real value of index funds becomes more apparent. Quite a few diversified funds in India are largely a reflection of index funds since a chunk of their portfolio is invested in index heavyweights. Therefore, you end up paying a higher Total Expense Ratio (TER) for limited benefits. The difference in TER is as high as 140-150 basis points in many cases. Index funds help you overcome this challenge.

Let us look at the future now! In India more than 70-75% of the fund managers actually beat the index in India while in the US it is just about 10-15%. That is more because there are still ample opportunities for alpha in the Indian markets. That may not really last for too long. Also, it has more to do with the construction of our indices. Indian fund managers do manage to beat the index in good times but tend to falter in bad times. Actually, one has to wait for the index methodology to get tighter and information flow more efficient, the returns between active funds and passive funds will reduce to a much lower spread. That is when the cost differential will really prove to be material and it is that that your index outperformance will really be visible. That is the key.

An investor has got to remember that index funds have not been great performers in the past. That is also because index funds in India have a higher tracking error. However, it is surely an idea which may become a lot more attractive in the coming years. More importantly, when you appreciate the risk scale in which it operates! There are two simple reasons for the same. Firstly, it is hard to fund managers to consistently beat the index. Secondly, it is hard for investors to precisely spot such a fund manager.