It's the right time for long-term investors

The current bull run, which began in April 2003, shows no signs of abating. Barring the odd hiccups every once in a while, both the sensex and Nifty have shown a consistent upward trend.

To answer the question whether 'it is a time to exit index funds?' one needs to understand what index funds are and how they work. Index funds are mutual fund schemes that purport to invest in a basket of stocks similar to that of its benchmark index and in the same proportion. This proportion is same both for stock as well as sector allocations. The performances of such funds are, therefore, closely linked to the performance of the underlying benchmark index. In India, we have index funds that track either the S&P CNX Nifty or the BSE sensex. Both are largecap indices and therefore, by default, the index funds tracking them are 'largecap' funds.

Index funds differ from regular diversified equity funds in the sense that index funds are passively managed whereas diversified equity funds are actively managed. And while the topic of 'active vs. passive managed funds' is open to debate, the fact is that passive management reduces the cost of operating funds and thus enhances the returns such funds generate. In contrast, active fund management enhances the chances of outperforming the market average, reflected by the indices.

Investors, looking to invest in quality stocks across the leading sectors, can take a medium to long-term view and patiently ride through the market gyrations, can consider investing in index funds. The answer to the question on whether to exit index funds, is 'No'. For common sense tells us that an exit from equities per se should be when the markets are on a high and entry should be when the markets look 'attractive' and valuations look relatively cheap.

In fact, we should be thinking the other way round: at these levels, it's a good time to invest in the index. The one thing that investors should keep in mind though is that mutual funds per se are not an investment avenue for the short-term as they invest in a basket of stocks as opposed to directly investing in equities, which is stock specific. One, therefore, needs to have a medium to long-term view to derive any benefits out of such investments.

Active funds perform better

There's a widespread belief among proponents of index funds that the index funds handily beat actively managed funds over the long-term. I've met otherwise knowledgeable people making this statement with an air of great authority, in that 'everyone knows' tone of voice. However, when challenged to provide some hard numbers to back up this claim, one never gets anything except a vague reference to some hazily-recalled American study that someone once heard of. Often, it will be said that actively managed funds may do better than indices for a short while, but in the long run, the indices will trump you.

Fortunately, the study of long-term investment performance is not one of those areas where one has to go by anecdotes or opinions. It is a field uniquely suited to hard numbers, the harder the better. And here are some of the hardest you'll find about this matter.

At this point of time, there are 60 actively managed diversified equity mutual funds in India that have existed for five years or more. If you were to add the sensex and the Nifty to these 60 and rank the resulting list for five-year investment performance, you'll find that the sensex is ranked 50 out of 62 and the Nifty 58 out of 62. It is true that you take a shorter period, say, one year, you'll find the sensex and the Nifty doing better with the sensex ranked at 101 out of 169 and the Nifty 87 out of 163 but that's better only compared to their longer-term performance.

No matter how detailed a look one takes at the numbers, the truth is that there are odd periods when the indices do better but most of the time, most active funds beat them handily. This is actually the opposite of what indexing fans would have one believe. However, one is by no means wedded to the idea of active management. In fact, one happens to think that fund management standards in India are declining and eventually, the indices will start doing better than the average (but not the better) funds. But when that day comes, there won't be any need for debates and opinions, hard numbers will prove it beyond doubt.