Index funds for the long run

Akash believes that actively-managed funds always do better than the index. An actively-managed fund is one where the fund manager uses his expertise to select a portfolio of stocks. It is hoped that this will provide better returns than the index. Diversified equity funds fall under this category. Typically the fund manager has a team of people who help him in his decisions. The costs of the fund manager and his team are borne by the investors in the mutual fund.

Indira was advocating that they should follow a passive approach to investing. This is frequently referred to as indexing. It is achieved by investing in an index fund. An index fund is an equity mutual fund that invests in stocks that constitute a stock index,such as the BSE Sensex or the NSE Nifty. The amount invested in these stocks is in the same proportion as stipulated by the index. As a result,index funds do not depend on the expertise of an individual fund manager. The returns from these funds are closely linked to those produced by the underlying index. Index funds usually have a much lower management fee compared to that of an actively managed equity fund. A sub-class of index funds,exchange-traded funds (ETFs),carries even lower costs than index funds.

“Does this clarify each of your points of view?” I asked Akash and Indira. They both nodded in agreement. “Let us then proceed with our discussion,” I said.

Go by past performance

A number of studies have been carried out in the US on index funds versus actively-managed funds. These studies have shown that it is difficult for a particular actively-managed fund to consistently outperform the index over long periods of time. Over a 15-year period two-thirds of all the actively-managed funds provided poorer returns than the index. Studies in India are also now beginning to show similar results. It is therefore recommended that a low-cost mutual fund is the ideal investment for long-term investors. Indira smiled and looked at Akash with an “I told you so” expression.

Akash immediately responded,“How can you say that? I can show you many actively-managed funds that have given superior returns to the index.” He reached for a file with the data. “That is correct”,I said. Akash looked confused.

“Those funds form the one-third of the funds that actually outperform the index,” I said. Akash relaxed,believing that he now had the upper hand in the debate. I continued. “It is not that an index fund is going to be the best-performing fund over any given period of time. That is certainly not true. There will always be actively-managed equity funds that will do better than index funds. However,it has been found that no fund can consistently outperform the index over long periods of time. The top performers in a particular five-year period have at times found themselves at the bottom of the table in the next five-year period. Also,it is practically impossible to predict in advance (when one is actually investing one’s money) which fund will be a top performer in the period ahead.”

Bottomline

Akash is right. There is no doubt that in any given period,some actively-managed funds will post better returns than the index. So by investing in an index fund you are definitely not going to be ranked among the top-performing mutual funds in any given period.

But the top performers could be there by luck rather than by skill. That is what makes Indira’s point of view extremely important. She believes in investing her long-term savings in a low-cost index fund.

Trying to find a top-performing actively managed fund may actually cause wealth to be destroyed in the long term as you switch from one fund to another. Since life usually gives us only a single long-term chance at equity investing,we cannot leave it to luck. Index funds are a safer and better long-term option.

The debate resolved,we continued with our breakfast and had an enjoyable morning.

The author,a certified financial planner,is the chief executive of Pune-based Sardesai Finance.

Email: ceo@sardesai.com