Akash and Indira were involved in a heated debate at breakfast. This is one couple I knew where both the spouses take equal interest in their financial investments. This morning’s debate was about long-term equity investments. Akash said that actively managed funds such as diversified equity mutual funds always do better than the indices. The indices are typically the BSE Sensex or the NSE Nifty. Indira argued that they should park their long-term investments in a low-cost index fund. As I walked in to join them at the breakfast table, both turned to me and asked which one of them was right. “It is an interesting debate. Let me explain,” I said.

Active and passive investing

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.

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