Benefits Of Investing In Index Funds That Go Unnoticed

Across a number of my past articles I have spoken about the major benefits of investing in index funds. But there are a number of other benefits to holding index funds. These usually go unnoticed. But they contribute just as much to the effectiveness of index funds. Therefore in today's post I am going to be talking about these less apparent benefits of index funds in detail.

Eliminates Uncompensated Risks

Bearing investment risk is justified only when it is adequately compensated for. The information ratio is a metric that quantifies the extent to which we are compensated for bearing incremental investment risk. It shows the degree of incremental return generated by a mutual fund for every 1% of additional risk taken over the benchmark index. A value of 0.5 is usually regarded as an acceptable information ratio. In other words an active fund must be able to generate at 0.5% of incremental return per annum for every 1% of additional risk taken. The 10 year information ratio for direct plans of a sample of around 25 actively managed large cap funds is laid out in the table below.

Notice that none of these funds have an information ratio of 0.5 or more. Some funds above even have negative information ratios. The data therefore offers eye opening takeaways for investors. Actively managed funds (and any strategy reliant on active management) expose us to greater volatility and concentration risk. But the market almost always punishes us for bearing the incremental risk. An index fund allows us to avoid these uncompensated risks completely. We would be able to capture the average market return while bearing baseline market risk. This represents a much more viable proposition for investors. 

The SPIVA Reality 

Before evaluating investment performance it is essential to understand the concept of base rates. Base rates represent the objective statistical probability linked to an event or outcome. The base rates linked to active funds outperforming their benchmarks are not at all in our favour as investors. This is borne out in the data given in SPIVA India Scorecards. The most recent edition of the scorecard is the SPIVA India Mid Year 2026 report. It shows that 74% of actively managed Indian large cap funds, 80% of ELSS funds and 82% of mid and small cap funds underperformed their benchmarks during the 10 year period ended June 2026 (June 2016 - June 2026).

Also 25.7% of active funds across all categories were liquidated or merged out of existence during this period. This implies that picking an active fund that has a reasonable chance of surviving a decade is a challenge in itself. In theory, one could try and pick one from the minority of funds that outperform the benchmark. But it is impossible to do this consistently and accurately in advance. So there is no point in trying to do this. Also the funds that outperform the benchmark keep changing every couple of years.

The SPIVA India report shows that the top quartile (top 25%) of actively managed equity funds earned 14.49% over the preceding 10 year period. The second, third and bottom quartile funds earned 13.16%, 12.29% and 10% respectively. We must also remember that the past 10 years have been a relatively favourable period for Indian equities. So these returns have been earned in a high return environment. Also the benchmark return for this period was 14.37%. The return from a top quartile fund during this period was 14.49%. Therefore the reward for picking a top quartile fund stands at a microscopic 0.12%

On most other occasions in life we do not participate in opportunities where the odds of success are not in our favour. But when it comes to our investments, we suddenly place immense confidence in our ability to cherry pick a winner. But the data shows that the reward on offer for cherry picking winners is simply not worth the time and effort demanded. We are therefore better served sticking to index funds. It negates the very likely outcome that we pick an underperforming active fund.

Complete Control Over Portfolio Friction

We have little or no control over the way investment products are structured. We have no control over the risks and returns involved. But we can control portfolio friction. Portfolio friction refers to the reduction in our net portfolio returns due to taxes, inflation and costs. We have no control over taxes and inflation prevailing in the economy. But we retain consummate control over the costs we pay on our investments. So we must exercise that control to the fullest at every opportunity. 

Heightened portfolio friction is a natural consequence of active management. Active fund managers constantly churn stocks in a fund to justify their existence and (mostly non existent) competence. And as shown earlier, such efforts to prove their ‘skill’ almost never ends well for investors. But this does not stop them from charging and justifying exorbitant costs. Some of these costs may also be hard to understand and discern. The end result invariably sees our portfolios bleed to death caused by a thousand cuts. 

Index funds offer complete transparency and control over costs. Firstly, SEBI regulations cap expense ratios of index funds to a maximum of 1% per annum. Further Nifty 50 index funds (the most viable index fund option at present) come with maximum costs of around 0.2% per annum. This makes them the lowest cost mutual funds available. Also all major mutual fund houses in India offer a Nifty 50 index fund.

The cutthroat competition between fund houses would therefore see expenses ratios remain where they are for the foreseeable future. Retail investors would never have enough bargaining power to negotiate with the mutual fund industry on costs. The transparency and control that index funds offer is therefore a boon for retail investors.

Final Takeaways

Academicians, media and finfluencers constantly advocate the supremacy of actively managed equity funds over index funds. This would make it seem like those not employing active management strategies are the ones who lose out. But genuine practitioners of finance would know that the exact opposite is true in reality. We must see ourselves as rational allocators of capital. This implies that we are not here to compete against other investors around us. And we certainly aren't trying to win awards for holding the best performing portfolio. We are simply looking for the best bang for our buck on the way to financial independence. 

Serious investors realise that having enough money to meet financial goals when required is all that matters. They realise that investing in index funds does not mean that they are settling for the average. It represents the most viable, statistically sound and efficient option available to investors Index funds should be the norm with actively managed funds being the exception.