Busting Index Investing Myths - I : Basic Misconceptions

Index funds are progressively finding greater acceptance among Indian investors today. But a number of myths regarding index investing are still prevalent. Some of these myths are born from an improper understanding of mutual fund construction and performance. Others are born from misconceptions about the concept of index investing. Today I will touch upon four such fundamental myths propagated about index investing and systematically bust them. 

Exposure To Low Quality Stocks Renders Index Funds Unattractive 

This argument makes the inclusion of low quality stocks seem like a fundamental flaw of index investing as a strategy. But such is not the case. Index funds are constructed on the basis of Free Float Market Capitalisation (Current Market Price × Number Of Publicly Available Shares). A broad market index therefore holds all stocks within a particular segment of the market. Equity returns tend to be heavily skewed. In other words it is a select few stocks within an index that generate the majority of its returns. The concept of dispersion analysis helps understand this point. 

Dispersion highlights the degree of outperformance or underperformance attributable to a stock. Dispersion analysis carried out for the Nifty 500 index over 10 year periods shows that ~90% of the cumulative gains from the index come from ~15% of its constituents. 10 year rolling returns of ~55% of constituents have been shown to be lower than the risk free rate of return. Returns from government bonds or fixed deposits held with large commercial banks can be used as the risk free rate of return. 

Also, the definition of the term quality is subjective when applied to stocks. The stock of a good company available at an exorbitant valuation makes it a low quality investment. Likewise, the stock of a bad company available at a dirt cheap valuation would be a high quality investment. The equity markets at any point in time would consist of a mix of laggards and wealth creators. 

Active investors and fund managers may miss out on some or all of the wealth creators. They are also likely to hold a few laggards at any given point in time. There may also be instances where an actively managed portfolio holds a few laggards and no outperformers. An index portfolio represents the market as a whole. It therefore holds both laggards and wealth creators. Index investors may therefore hold a few laggards in their portfolio. But they are guaranteed to not miss out on any of the wealth creators. 

The fact that index funds are weighted on the basis of free float market capitalisation also works to investors’ advantage. This is because laggards are naturally assigned lesser weights in the index over time. Wealth creators on the other hand would be assigned higher weights. This means that the impact of laggards on the overall cumulative gain from the index fund is minimised. Therefore inclusion of low quality stocks in the index is a matter of design and not a fundamental flaw of the approach.

Investing Directly In Stocks Through A Discount Broker Is A Better Option 

Some may argue for the benefits of holding stocks directly through a discount broker like Zerodha. But there are a few things to consider here. It is impossible to accurately predict which stocks would be outperformers during our investment horizon. This is because it requires us to accurately predict the behaviour and performance of the market. The market is essentially a group of investors coming together to buy and sell stocks. Therefore market performance is simply a reflection of investor behaviour at large. Predicting market performance therefore requires us to understand and predict human behaviour. And this is impossible for any of us to do.

Most stocks in an index portfolio pay dividends. When stocks are held directly, these dividends are taxed at applicable slab rates. This creates an additional tax liability for investors. Most investors with equity portfolios worthy of note typically pay taxes at effective rates of 30% or more (including surcharges and cess). So what is saved in brokerage is eaten by taxes. This significantly depletes the value of the final corpus for those who hold dividend stocks. Investors holding individual stocks would also need to pay STCG/LTCG taxes as applicable every time they churn stocks in their portfolios. 

Index funds work around each of these issues. They automatically reinvest dividends paid out by constituent stocks of the benchmark index. Taxation is deferred until the actual point of future sale. This eliminates the tax leakage caused due to the annual slab rate liability. Periodic reconstitution of the index involving addition or deletion of stocks is executed with zero tax impact for the investor. 

Most investors who invest directly in stocks typically do not reinvest any dividends received. This allows them to only enjoy the price return from their portfolios. Index funds allow investors to capture the total return (price + dividends) of the index. Comparing data from the Nifty 50 Price Returns Index (PRI) and Total Returns Index (TRI) over a 20 year period would be useful here. The data shows that the TRI offers an incremental return of anywhere between 1.3% and 1.5% compounded annually over such periods. 

Index Funds Do Not Offer Downside Protection

This is true to some extent because index funds capture 100% of the impact of a market drawdown. But it is erroneous to believe that active funds may fall less than the market and therefore provide downside protection. Empirical data has consistently proven the exact opposite to be true. Most actively managed funds experience drops that are worse than the index. Data from stress tests carried out by National Institute of Securities Markets (NISM) shows that ~75% of active large cap funds experienced drawdowns worse than those of the Nifty 50 TRI.

This was found to be true for all major market crashes in the recent past such as the Global Financial Crisis (2008) and the COVID crash (2020). And it would have been extremely difficult to identify the 25% that outperformed in advance. So achieving downside protection through actively managed mutual funds is extremely challenging.

Attempting to manage risk within the equity component of a portfolio represents a fundamentally flawed understanding of risk management. Risk management in a portfolio must be effected at the asset class level. This means risk is managed by regulating the allocations to equity and debt in the portfolio. Downside protection is therefore facilitated at the inter asset level rather than the intra asset level. 

This implies that the most effective way to guard against a 50% drawdown in a portfolio holding 70% equity is not to pick an active fund hyped for its downside protection. It is to reduce the equity allocation in the portfolio from 70% to say 50%. This represents a much more reliable way to achieve downside protection.

Index Funds Work In America, But Not In India

This is the mother of all myths about index investing. It is akin to saying basic mathematical operations work in America but not in India. The basic math underlying index investing remains true across the world. It states that before taxes and costs, the average actively managed portfolio would earn the same return as an index portfolio. This is because the portfolios of market cap weighted index funds are such that the weightage of each stock in them is the same as that of the portfolios of all active investors in that segment. When the weightage is the same, the return also must be the same.

But taxes and costs associated with investing have a decisive impact on the net return earned by investors. Therefore after taxes and costs the average actively managed portfolio is guaranteed to underperform the index portfolio. This is a matter of mathematical fact that remains universally true. It is supported by Nobel laureate William Sharpe’s seminal research paper titled The Arithmetic Of Active Management.  Data from SPIVA India scorecards only drive the point home further. 

The SPIVA India Mid Year 2026 Scorecard shows that 74% of active large cap funds and 82% of mid and small cap funds failed to beat their benchmarks. It is also important to remember that active funds carry significant holding costs. Regular plans of active funds tend to cost anywhere between 1.8% and 2.25% per annum. Direct plans tend to cost between 0.8% and 1.25% per annum. Combine this with turnover rates ranging between 50% and 80% as exhibited by most active funds. 

These data points collectively imply that the average active fund must beat its benchmark by anywhere between 1.2% and 1.5% per annum before costs. This represents the incremental return required just to match the net return from an index fund. The humble index fund that costs ~0.2% per annum will therefore always enjoy an almost insurmountable advantage against active funds over the long term. 

We're Not Done Yet 

This week's post focused on index investing myths born from basic misconceptions about the concept of index investing. But there are more myths that are yet to be busted. Next week's post will focus on arguments against index investing born from an incorrect understanding of how index funds work.