Underrated Benefits Of Investing In Index Funds

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.

Complete Transparency And Control Over The Controllables

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 the costs that we pay for our products. So we must exercise that control to the greatest extent possible. 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.

The Information Ratio

The information ratio is a metric that pertains to the performance of actively managed mutual funds. It shows the degree of incremental return generated by the 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 30 actively managed large cap funds is laid out in the graphic below.

Notice that none of these funds have an information ratio of 0.5 or more. Some funds above even have negative information ratios. This shows that none of these funds adequately justify the incremental risk that they take. And if the incremental risk cannot be justified, there is no point in bearing it. Investors would therefore be better off bearing default market risk and capturing market returns through index funds.

Reduces Impact Of Negative Outcomes

One will always be able to find actively managed funds that beat the benchmark in any given year. But such funds are few and far between. This is borne out in the SPIVA India Mid Year 2025 report. It shows that 73% of actively managed Indian large cap funds, 87% of ELSS funds and 82% of mid and small cap funds have underperformed their benchmarks. This is laid out in the graphic below.

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 good period for Indian equities. So these returns have been earned in a high return environment. In a normal or low return environment, each of these figures would drop by around 2%.

So unless one picks a fund from the top quartile in hindsight, they can expect to earn 8 to 11%. These returns are comparable to that of an index fund (if not worse). The odds of picking a fund from the top quartile are also against the investor. Investors are therefore better served sticking to index funds. This negates the very likely outcome that they pick an underperforming active fund.

Final Takeaways

Academicians, media and finfluencers constantly advocate the supremacy of actively managed equity funds over index funds. This would make it seem like actively managed funds are the norm and index funds are the exception. But genuine practitioners of finance would know that in reality, it is the exact opposite which is true. Index funds should be the norm for investors with actively managed funds being the exception. And the points discussed above are just a few of the many reasons as to why this is true.