June 06 , 2012
Mutual funds can be classified into two on the basis of type of fund management. They may be either actively managed funds or passively managed funds.
Index funds are passively managed mutual funds. By passivity we mean the fund manager does not make active decisions about what stocks to invest in. Index funds try to mimic the returns of a stock market index. This is achieved by investing in all or almost all of the stocks comprising the index and in the same proportion as they are in the index as far as possible. Some examples of index funds are ICICI Prudential Index Fund and HDFC Index Sensex Fund.
As opposed to this actively managed funds have money allocated in diverse stocks as chosen by the fund managing team. These obviously try to outperform benchmarked indices. The portfolio of such funds changes dynamically as compared to index funds.
Now comes the question of whether to invest in an index fund or an actively managed fund. Two parameters are of importance: cost of investing and performance.
From the expenses point of view index funds have lower expense ratio; which is the percentage of returns to be paid as management fee, as compared to actively managed funds, since the fund manager doesn't have to do much brain racking and stocks are bought and sold less often, eliminating transaction fees for the fund house. For long term investment of several years a fee higher than by just 0.5% would eat up a huge amount of your return due to the effect of compounding.
In India there are umpteen numbers of actively managed funds that manage to beat their benchmarked indices year after year. However this trend cannot be expected to continue forever into the future of Indian markets. In developed countries like the US, performance of actively managed funds is usually not better than index funds. Most investors there choose from a variety of index funds. The best fund managers in India may be able to outperform indices for a couple of years more.
Equity funds in general are a function of risk profile; index funds are useful if you are short on time and energy to do further research yourself.
Index funds are again great if you are planning for retirement some 10-20 years down the road. Simply start a long term systematic investment in an index fund. As long as India grows and there is no major catastrophe, it should hold you in good stead!