Well, most fund managers can't. And that's where an index fund comes into play.

An index fund follows the underlying principle of passive investing which means that the fund does not burden itself by trying to outperform the benchmark index, it simply replicates it. The index fund invests in the same companies as the benchmark index in exactly the same proportion. Consequently it moves in tandem with the benchmark index and duplicates the latter's growth and decline. Allowing for a tracking error, the performance of the index fund is a mirror image of that of the benchmark index.

Who are the prime candidates for investment in an index fund? Given the basic philosophy of an index fund, it is ideal for investors who do not have the time to monitor the index and would simply like to invest in a fund that does the same.

Another reason why an index fund is a superior (and a more rewarding) investment avenue is because of the tendency of the index to outperform other investment avenues. A study by Templeton India Mutual Fund reveals that over the period 1980-98 the BSE Sensex gave annualised returns of 20.16%. Compare this to gold, which gave an annualised return of 7.62%, bank FD (9.74%) and company FD (14.47%). Inflation in this period increased 9.19% annually. So the real returns on all these investments would fall even further, with the Sensex offering the highest returns.

In addition to owning a well-diversified portfolio across a range of sectors, the investor will also benefit from investing in a cost-efficient fund. This is because unlike an active fund, an index fund has lower research and advisory costs. Moreover, the fund has lower transaction costs as it does not try to beat the index.

But an index fund is a comprise all the same. An investor will always see his investments moving in line with the index. While this is good thing in a rising market, it will prove distressing in a falling market. Moreover in the absence of active investing, the fund does not attempt to exploit the inefficiencies in the markets by buying stocks available at attractive valuations, or buying fundamentally sound stocks outside the index. The opportunity cost in such a scenario could be quite significant.

So an investor with an investment horizon of say 12 months, could review the performance of existing index funds and take a decision on whether his needs can be best fulfilled by an index fund or by a plain vanilla growth fund with sector allocations somewhat in line with the index. (Try our interactive Compare NAV Returns section in the mutual funds page to compare the performances of various index funds.)

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