There is little doubt that actively managed diversified equity funds have drawn excessive investor attention by outperforming all benchmark indices and surpassing investor expectations. The last time we saw an outperformance of this magnitude was in 1999-2000. So obviously when you have active funds that can beat the index comfortably there is little, if any, reason to look at investing in the index. After all investment is all about generating a return, and the investment avenue that does this most efficiently merits most attention. There is no reason why the principal of 'Survival of the Fittest' should apply only to the evolution of the species.

At face value this probably rings true. But investments isn't only about generating a return. Its about generating a return at a risk commensurate with your own risk appetite. In that context, index funds need a look-in. When we spoke to Mr. Rajat Jain, CIO – Principal Mutual Fund (which has the largest index fund in the country), about the viability of an index fund, he had this to say, 'If there is appreciation in the index and the investors wants to capture the growth, then being in the index can help. Of course, the active fund manager will also clock growth at the same time, which is why we don't say that it's a question of either/or, it can be both. The investor must not only be in the index, he must also be in the index, maybe upto the extent of 20% and the balance he can allocate in active funds.'

There is a sound investment rationale for investing a portion of your assets in index funds. Below, we have outlined a few reasons.

1. From a pure diversification perspective, index funds complement, and not compete with, the actively managed funds in your portfolio. It is always a sound investment decision to diversify across asset classes and across segments within the same asset class. However, you nevertheless need to exercise caution because active funds invest in index stocks anyway, so for you to really diversify you may need to either look at a different index altogether or you could select an index plus fund. (Index plus funds invest largely in the index with the flexibility to invest a portion of their assets outside the index).
   
   

2. Outperforming the index in a big way is a good thing only in a rising market. When markets fall, most active funds fall harder than the index. This is mainly because active funds seem to have mastered the art of posting capital appreciation in a rally but not the art of risk mitigation in a bear phase. Index funds move in line with the index in a falling market and provide the much-needed risk mitigation. This was evident in the post-March 2000 scenario when most active funds were in a free fall and fell harder than the index.
   
   

3. Index funds present a good opportunity to enter equities even at relatively higher levels. We have seen actively managed funds outperform the index in a big way. So they are more 'overheated' than the index. For instance, if the index has appreciated by about 40% and your active fund has surged by 80% in the same period, you may be making a mistake by buying more of the fund rather than the index. Its smarter to buy an index fund at this level as a hedge and then switch assets to an active fund after the correction/slide sets in. This is because the correction in your active fund will be more than in the index fund. This is how you can use the index fund as a risk mitigator.
   
   

4. Index funds have lower trading and fund management expenses. This has a direct impact on the return. The lower expenses (vis-à-vis active funds) gets compounded over the years and 'adds' to the return.

As we have outlined, there is merit in investing at least a portion of your assets in index funds. And for a first time equity investor, there are few options that can match the efficiency of an index fund. Although its a concept 'borrowed' from developed markets where active funds find it quite challenging to outperform the index, the utility of an index fund will unfold increasingly, going forward.