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Do Not Buy Index Funds

As the name suggests, mutual funds that invest their entire corpus in the
- top 30 companies that make the BSE Sensex (or the 50 companies that comprise the NSE Nifty)
- and, in the same proportion,
are known as Index Funds.

Since the companies to invest in are already known, as also the exposure across each company, a fund manager has no role to play here. Thus, index funds are also known passive funds.

Second, with no need of any active management or regular monitoring, the annual fund management charges in index funds are much lower as compared to the actively managed funds.

Third, given that these funds mimic the market, one can always expect to earn the benchmark returns. There is little risk of under-performance with index funds.

Despite these many advantages, index fund do not make a good choice.

Why?

As we all know, India is a growing economy. As such, there are many small and medium sized companies that will exhibit high growth. They will become large and hugely profitable over the next few years / decades. In short, there is lot of action in the non-index companies. When we invest in the index funds, we miss out on the growth potential of these companies.

Given numerous opportunities in the non-index segment of the stock market, an actively managed diversified fund with a mix of Nifty / Sensex companies and the non-Nifty / Sensex stocks, has very high probabilities of beating the Index.

In other words, with very limited risk, we can earn much higher returns in actively managed mutual funds vis-à-vis the index funds.

This is amply proven by the performance of both these kinds of funds, over the last 10-15 years.

Therefore, at present, an active diversified fund is a better investment opportunity than a passive index fund.

People often give the example of US, where index funds regularly feature among the top performers.

However, they forget that US is a mature market; with comparatively much lower growth rates when compared to India. Therefore, it is not easy for a fund manager to discover hidden gems and beat the index. As such, in US the index funds... with low / nil fund management charges... are often preferred over the actively managed funds. 

Hence, it would not be prudent to follow the US example here... at least till India becomes a developed and mature economy. But this, I guess, is still a few decades away.

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