Index funds have been very popular in developed markets for the last few decades. Index funds are becoming more relevant and more popular in Indian markets too.
Especially as the stock market becomes more liquid and transparent, managed funds have little advantage over index funds.
Warren Buffett had famously made a bet with a Hedge fund manager on picking up any five funds that would beat an index fund over 10 years. Warren Buffett won the bet.
The same holds true to you and for Indian market at least for large cap funds. Actively managed funds still have an advantage in Mid/small cap funds.
When it comes to large caps it is becoming increasingly hard to beat index funds. Let us see few reasons why why it is so hard to beat it index
Expense ratios
Index funds have an expense ratio. Expense ratio is the fee that is deducted from your overall investment for the service provided by the fund house.
There is a big difference between the expensive ratio of index funds and actively managed funds.
For example index funds can have expense ratios as low as 0.05%. whereas most actively managed funds have expense ratios of around 1%. If you have invested in a regular Mutual Fund expense ratio can go as high as 2.5%..
There is reason alone that makes a huge difference when you compare Returns spanning more than 5 years.
Imagine a fund manager has to create at least one percent extra return each year consistently so that it can match the return of the index. This is really hard when the information these days is very transparent with markets very efficient in discounting any new information.
Difference in return magnifies overtime time and it becomes more and more difficult to beat the index comparing Returns on more than 10 years.
Fund managers bias
To justify their higher expense fund managers at times have to take bold decisions. They have to either pick up lesser known stocks or with concentrated bets on few stocks.
While picking up stocks in the portfolio, fund managers can have bias either due to sectors he/ she is comfortable or based on conviction. This bet can pay off but if they don’t they result in a lower return for the fund.
Index hugging strategy
In order to not stand out when their fund selection goes wrong, most fund managers go with index hugging strategy. In this case they select stocks which are very similar to those in benchmark.
They then make small tweaks to the portfolio as per the judgement. For example they can create a Portfolio similar to Nifty 50 but can remove companies like Yes Bank, Zee Entertainment which are known bad performers.
They try to play safe because it is easier to justify to management when you are wrong along with the market versus when you alone are wrong.
But this strategy does not create better returns when compared to index. Most cases the higher expense ratio is not compensated by better returns in such actively managed portfolios
Excessive buying and selling in funds
Index has an advantage of lower churn in the portfolio. This is because it only has to match the composition of the index which doesn’t change too often.
whereas in actively managed funds fund managers have to decide and move as per the market. This usually results in a lot of excessive buying and selling which results in extra transaction costs.
Transaction costs are an expense which reduces your Returns.
Fund house mandates
Active funds also have to follow the rules set up by their fund house. For example fund Managers from HDFC have to follow rules and mandates set up by HDFC Asset Management Company.
So even if there is a conviction, an idea by a fund manager can not always go ahead with that. This makes them react slowly to take any advantage of market inefficiencies.
Information is quickly discounted in market
It is increasingly becoming difficult To trade with insider information. Information on Indian large caps is freely available with each company being covered by multiple analysts. This makes it very difficult for a fund manager to find information that will give them an advantage.
As stocks in Indian markets get more coverage by analysts, it will get increasingly difficult for fund managers to create Alpha.
 SEBI/Regulators guidelines
There are certain regulations setup by SEBI which restrict mutual funds to have a free hand in constructing a portfolio. For example they cannot hold more than 10% of their fund in one stock.
In recent times this has created a problem for large cap fund managers. In nifty 50 Reliance in HDFC has continuously outperformed and the wait of both the stocks is more than 10%. Fund managed fund managers cannot match this because of restriction which reduces their fund return when compared to index.
Difficult to beat collective wisdom
The index fund closely tracks respective indexes. For example Nifty 50 is made up of top 50 companies across sectors based on market capitalisation. Market capitalisation is defined by the price the collective market is willing to pay.
Price is decided by the market as a whole which is a result of collective wisdom.
For example D-Mart has consistently been overvalued but is priced based on the collective wisdom of the market. If a fund manager does not include D-mart in its portfolio simply because it is overvalued he would be robbed of the returns D-Mart gave over the past years.
For these reasons I believe it is increasingly difficult to beat Index Fund. Instead of focusing on the next big stock or mutual fund, it is always advisable to stick to index funds. Index funds will get average returns over a very long time. A simple investment will make you a lot of money if you stick with it over a long period of time.
