Index funds aim to replicate a particular index like the Bombay Stock Exchange's Sensex or National Stock Exchange's Nifty 50 share index, by holding all securities in the index in the same proportion as the index.
Since, these funds mirror a particular index, they follow passive management style and gives the advantage of lower fees as compared to diversified equity funds. The advantage of lower fees results in better returns to investor.
However, if an index fund fails to replicate its benchmark index in the same proportion, it may result into divergence in return positively or negatively. The difference between the index fund performance and the benchmark performance is called as "tracking error".
The disadvantage of investing in index fund is that the role of fund manager is limited and therefore investor may not be able to take advantage of fund manager’s investment management expertise.
In contrast, diversified equity funds follow active management style. The objective of the fund manager here is to outperform an investment benchmark index. Since, these funds follow active management approach, turnover (buying and selling of securities) costs are higher and this results into higher expenses for the fund.
The higher expenses dampen the return of the fund. The diversified equity funds benefit from the fund manager’ investment management expertise and this may work positively or negatively depending upon fund manager’ investment decisions.
Returns of index funds vs. diversified equity funds
A study of 20 index funds and 97 large-cap diversified equity funds selected by Morningstar showed that index funds outperformed the large-cap diversified equity funds category during the last one-year period as of February 2009.
However, during the three-year period, both of these categories registered -5.3% average returns. During the 10-year period, the large-cap diversified equity funds category registered an average return of 16%, while index funds posted an average return of 10.02%.
This shows that though in the short-term and also in the downside market, index funds fared well, compared with diversified equity funds, in the long-term, diversified equity funds outperformed index funds, owing to their active investment management approach.
We also looked at these funds’ performance against the market index. During the one-year and three-year period, index funds beat the BSE Sensex, which delivered -49.4% and -5.0% returns respectively.
However, they underperformed the National Stock Exchange's Nifty index, which generated -47.1% and -3.5% returns during the one- and three-year periods respectively. The situation was similar for large-cap diversified equity funds.
It is only in 10-year period that large-cap diversified equity funds outperformed the benchmark market indices, while the index funds underperformed.
Costs of index funds vs diversified equity funds
All things being equal, funds with high costs are much more likely to produce poor performance because of their cost disadvantage. However, all things aren't equal and many high-cost funds may also have weaker management, higher risk strategies, and fewer resources.
Due to lower turnover and passive investment style, index funds are more cost effective. The average expense ratio of 20 index funds studied was 1.3%, while the average for large-cap diversified equity funds was 2.2% as of February 2009.
While selecting a fund, it is important to choose a fund with lower expense ratio as low-cost funds double chances of success. The savvy investor should look for low-cost funds with sound fundamentals. Our research in the U.S. market shows that doing that increases your chances of success and greatly reduces your chances of dramatic underperformance.
With the field narrowed, consider which funds, active or passive, have the best combination of low costs, good-quality management, sound strategies, diversification, and stewardship you want. With patience, those funds should have a better chance of getting you to your goals.