Index Funds V/s Actively Managed Funds

While choosing from a universe of mutual funds schemes, we seldom wonder whether we should invest in index funds which are passively managed or in the actively managed funds like the equity diversified funds.

Basically, mutual fund schemes can be broadly classified as passively managed funds (better known as Index funds) or actively managed funds.

Index funds, as the name suggests are the funds where the fund manager has the mandate to duplicate a particular index (Ex: NIFTY, Sensex) by investing in the same stocks and in the same proportion/weightage. The returns of the index funds are also more or less identical to its benchmark.

On the other hand, actively managed funds are the funds where the fund manager has the liberty to choose scrip’s across different market caps where he finds opportunity and try to outperform its benchmark.

For someone who doesn’t have the time to follow & track the markets, but wants to duplicate a particular benchmark and stay invested for a long term, index funds are the right choice for him. In other words, index funds give the retail investors the chance to purchase the benchmark. 

However in a market like India, where everyone is talking about its growth story, would investing in an index fund prove to be a loss of opportunity?

In India, Index funds (passively managed funds) over the years have rarely beaten the actively managed funds. The opposite can be said about the developed countries like United States where the market is more matured and finding investing opportunities is a difficult task for the fund managers and hence difficult to outperform the benchmarks.

Let’s look at the historical performance of some Indian Mutual fund schemes:

		Returns
Scheme Name	Category	6 months	1 year	3 year	5 year	Std Deviation	Sharpe Ratio	Exp Ratio
HDFC Index Fund- Sensex Plus	Index	-2.30%	15.30%	9.70%	13.20%	29.98	0.38	1.00%
HDFC Top 200	Diversified	-3.10%	17.90%	15.70%	17.30%	31.16	0.54	1.79%

		Returns
Scheme Name	Category	6 months	1 year	3 year	5 year	Std Deviation	Sharpe Ratio	Exp Ratio
Franklin (I) Index- BSE	Index	-2.80%	12.30%	4.70%	10.30%	32.99	0.25	1%
Franklin India Blue Chip	Diversified	-1.00%	14.30%	12.00%	13.50%	29.09	0.45	1.83%

(Source: www.valueresearchonline.com & www.moneycontrol.com, data as on 27^th April, 2011)

From the returns front, diversified funds are the clear winners with a huge margin. The diversified funds normally have a higher expense ratio as compared to the index funds. This is mainly because of frequent buying and selling in them as against passively managed funds. However, they compensate well with the extra premium in returns.

 Also as we see in the above table, the Sharpe ratio of the actively managed funds are higher than the index funds, indicating a higher expected return from the fund for the risk it takes (given by standard deviation).

Hence, for investors who are willing to take slight risk and want to grab the opportunity of India Growth story, should opt for diversified funds so as to earn that extra premium over the long run.