Putting Your Money to Work: Why Index Funds Are a Reliable Investment Strategy

 A fantastic approach for creating long-term wealth is through mutual fund investing, but not all mutual funds are made equal. Mutual funds can be divided into two categories; active funds and index funds. While active funds are managed by experts who try to outperform the market by picking specific stocks and timing the market, index funds are passively managed funds that follow a certain market index, such as the BSE Sensex.

While each style of the fund has advantages and disadvantages, index funds generally beat active funds over the long term, according to recent studies and historical data. This is mostly a result of index funds' lower expenses and passive management approach, which leads to less trading and more long-term holding. As a result, index funds are a preferred investment choice among those wishing to use a reliable and profitable strategy for building wealth over the long term.

Why Active Funds Struggle to Outperform Index Funds Over the Long Term?

The difficulty with active funds is that they usually cost more than index funds. Compared to index funds, active funds have higher management fees and trading costs because professional fund managers have to conduct more research, analysis, and trading activities. The investor's returns may be significantly reduced by these additional costs, making it more challenging for the active fund to outperform the market.

Additionally, even while active fund managers may be skilled at evaluating and picking certain equities, they struggle to consistently outperform the market over the long term. This is due to the fact that active fund managers must rely on their ability to anticipate market trends and make investment decisions that are superior to those of the general market, which is a challenging task to achieve on a consistent basis. Investors may therefore end up paying more fees for active management that do not produce superior long-term returns.

"The best way to own common stocks is through an index fund" - Warren Buffett, CEO of Berkshire Hathaway

What Benefits Do Index Funds Offer?

One of the key benefits of index funds is that they have reduced costs and fees, which may lead to better net returns for investors. This is because index funds do not need to conduct the same amount of research and analysis that actively managed funds do as they track a particular index, such as the Nifty 50 or the BSE Sensex.

According to numerous studies, actively managed funds typically charge more fees than index funds. According to a 2021 Value Research analysis, the average expense ratio for active equity funds in India was 2.01%, compared to an expense ratio of 0.49% for index stock funds. Accordingly, active equity funds typically charged fees that were more than three times those of index stock funds.

Additionally, index funds' passive management approach encourages long-term investing rather than frequent trading, which can reduce transaction costs and maximize tax efficiency. Index funds might be more resilient to short-term volatility and less susceptible to market swings since they don't require as much trading activity as actively managed funds.

Better diversification of index funds can lower the risk of underperformance since they invest in a wide variety of stocks from different industries. It can help to reduce risk and the impact of any one stock performing poorly. For investors looking to create a diverse and well-balanced portfolio, this diversification can be especially helpful.

The Evidence: A Look at The Historical Performance

There is compelling evidence that, when comparing historical performance, index funds have beaten active funds in the long run. For instance, during the past 15 to 20 years, the S&P 500 index in the US has consistently beaten the majority of actively managed mutual funds. Similar trends are being seen in India.

Over a 5-year period ending in June 2021, more than 70% of large-cap equities funds (and more than 80% over a 10-year period) in India underperformed the S&P BSE 100 index, according to a report by S&P Dow Jones Indices.

Another study - SPIVA India Scorecard by S&P Global suggests that the bulk of Indian mutual funds have consistently underperformed their benchmark indices. According to the most recent data, released in December 2022, 45% of mid and small-cap funds and 94% of large-cap funds underperformed their benchmark indices during a 5-year period. While 50% of mid and small-cap funds and 68% of large-cap funds underperformed their benchmark indices over a 10-year period.

Source:  SPIVA India Scorecard

Other studies have observed similar results as well. Only 34% of India's 346 actively managed equities mutual funds were able to exceed their respective benchmark indexes over a 5-year period ending in June 2019, according to a report by CRISIL in 2019.

"The index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense" - Charlie Munger, Vice Chairman of Berkshire Hathaway

Here are a few instances of active Indian mutual funds that have consistently underperformed their respective benchmark indices:

The benchmark Nifty 500 index has regularly outperformed the DSP Focus Fund over the past 5 years. The fund's 5-year return as of March 2023 was 11.68% vs the benchmark's 11.52%.

Over the past 5 years, HDFC Capital Builder Value Fund has regularly underperformed its benchmark Nifty 500 index. The fund's 5-year performance as of March 2023 was 8.69% as compared to the benchmark's return of 11.52%.

Over the past 10 years, Aditya Birla Sun Life Midcap Fund has lagged its benchmark Nifty Midcap 150 index. The fund's 10-year return as of March 2023 was 15.69% compared to the benchmark's 18.21%.

Here Are Some Probable Counterarguments Against Active Funds

The first counterargument is that in certain market conditions, such as times of market turbulence or recessions, active funds may outperform.

Although active funds may perform better in some market scenarios, it's vital to remember that these situations can be unpredictable and hard to profit from regularly. Additionally, the long-term advantages of index funds, such as lower costs and greater diversification, frequently outweigh the potential benefits of outperformance during particular market conditions.

Secondly, active funds give investors the chance to choose competent fund managers who are capable of beating the market.

Despite the fact that there are many skilled fund managers, the evidence suggests that consistently beating the market is quite challenging. In actuality, even with the assistance of knowledgeable fund managers, many active funds underperform their respective benchmarks. Investors can avoid the danger of selecting a poor fund manager and gain from the market's overall success by making investments in index funds.

Thirdly investors may not have the possibility of making substantial returns from index funds. Active fund managers have the flexibility to place focused bets on certain stocks or industries, and if they are successful, their investments might produce astronomical profits.

Absolutely, index funds do not necessarily offer the same potential for large returns as some active funds, but they can deal with the possibility of severe underperformance. Investors can boost their net returns and more successfully reach their financial goals by avoiding the excessive fees connected with many active funds.

"I recommend the S&P 500 index fund. I think it's the best investment" - Peter Lynch, former manager of Fidelity's Magellan Fund

In conclusion, index funds are preferable to active funds in a number of ways, including lower costs and fees, a passive management approach, diversification, and record outperformance. The research suggests that active fund managers have difficulties in consistently outperforming the market over the long term, despite the fact that they may have the freedom to make targeted bets on certain stocks or industries.

Despite potential objections, index funds are often a better investment choice for most individuals due to their many advantages. Index funds have the potential to provide higher net returns over the long run by lowering costs and trading activity. Investors who are committed to creating long-term wealth should think about switching their investment approach to include index funds.