Passively managed index funds and ETFs (that was kind of completely ignored category of funds by retail investors in India) have slowly started gaining momentum. Notably, the concept of index funds is quite popular in developed markets like the U.S.

Seeing the underperformance of the actively managed funds against the key benchmark indices like S&P BSE Sensex and Nifty 50 index in the last one year, many investors now want to get the taste of passively managed funds. It is noteworthy that passively managed funds tracking the popular index have managed to outperform their active peers by a noticeable margin.

All thanks to index heavyweights like Reliance Industries that have been driving the rally in larger indices.

Due to the increasing popularity in this space, mutual fund houses have launched index-based funds, vying for a piece of the pie.

• Mirae Asset Nifty 50 ETF

• Tata Nifty ETF

• Aditya Birla Sun Life Nifty Next 50 ETF

• ICICI Pru Nifty Next 50 ETF

• SBI-ETF Sensex Next 50

• ICICI Pru S&P BSE 500 ETF

• SBI Quality ETF

For those who don’t know what Index funds are…

Index funds are a category of Mutual funds that try to imitate the portfolio of a market index (say Nifty 50 or S&P BSE Sensex) by investing in stocks that are a part of the Index in the same proportion as in the index. These funds are passively managed and simply try to replicate the performance of the underlying benchmark.

Currently, index funds are coming into the limelight for the following reasons.

1. Short-Term underperformance by Actively managed funds

   In February this year, the regulator mandated mutual fund houses to compare the returns of their scheme to Total Return Index (TRI) Benchmark. The shift from vanilla index returns to TRI gave a clear picture of the schemes’ performance versus its benchmark. This also enabled the investors to see that the alpha generated by the actively managed funds is disappointing. The number of actively managed funds outperforming the benchmark has come down and has even raised doubts in the minds of investors about the potential of actively managed funds.

   Followed by the short-term underperformance of actively managed funds, many investors doubt the human abilities to choose good companies on a consistent basis. In short, they are apprehensive about active portfolio management. Although they still recognise and acknowledge the importance of equity as an asset class and believe in the return potential of equity assets, there has been some shift in focus towards passively managed funds that mimic an index. It will be interesting to see how long this trend of underperformance by active fund managers will continue.

2. Lower expense ratio

   The expenses charged by actively managed funds are much higher as compared to passively managed funds. While the expense ratio of actively managed funds varies within the range of 1.5%-2.5%, the passively managed index funds and ETFs typically have an expense ratio of about 0.25%-0.50%. Passively managed funds turn out to be more economical for investors and also boost the net returns the fund generates for its performance. Clearly, investors do not prefer paying someone a higher fee for poor performance.

Are investors right in switching to Index funds, now?

Index funds are popular in developed countries like the U.S. It is noteworthy that the U.S. is a saturated economy, where the active fund managers find it difficult to generate alpha over the benchmark. However, India is still a growing economy, which still offers lots of opportunity to active fund managers.

Notably, the size of the mutual fund industry in the U.S. is about 80% of its GDP, while the Indian mutual fund industry is just about 12% of the GDP. So, there is a long way to go before we get to a level where the active fund management becomes completely ineffective and redundant. In our understanding, we are far away from having a complete passively managed fund industry. Do not forget, a large number of investors continue to prefer market-beating returns over market linked returns.

[Read: Should You Be Investing In Passive Funds Now?]

If you wish to get the taste of passive investing, make sure you do not go overboard on index funds. Maintain a fair allocation between actively and passively managed funds. An allocation of 80:20 could be fair if you still aim to beat the markets.

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