Mutual funds have been gaining in popularity among investors over the last decade or so. They have established their identity as a preferred mode of investment, given their track record of yielding better returns than fixed deposits, public provident fund or insurance-linked investment products. Of late, though, a new debate has started — should one go for passive or index funds, or stick to actively managed ones?

An index fund is a mutual fund that imitates the portfolio of a specific index like Sensex or Nifty. It follows their benchmark indices no matter how the overall market performs. Investment legend Warren Buffett recommends index funds for retirement saving plans. The primary difference between a passive and an active fund is the cost. Index funds have lower expense ratio as the fund manager does not need to actively pick stocks and time the market. Instead, the manager has to just mimic the profile of the index.

While investors in developed markets have been inclined to invest in passive funds for a long time now, the idea has been catching the imagination of Indian investors of late. According to Chintan Haria, Head (Product Development and Strategy), ICICI Prudential AMC, 2020 was a landmark year for passively managed products in India, be it index funds or ETFs.

“At a time when the market was reeling under the effect of the pandemic, passive investments broke new ground both in terms of investor interest and also assets under management. This, despite passive investing being at a nascent stage in India,” he said.

Most industry experts feel even though index funds may not beat actively managed funds every single time, they tend to be more consistent in their performance compared to actively-managed funds over a long period. Also, with the investment landscape maturing over the years, actively-managed mutual fund schemes may struggle to beat the broader index in the future.

Another important factor that comes into play is the management cost of mutual funds, which in turn affects the overall returns from them. Since these costs are relatively low in case of passive funds, the active fund may have to outperform the passive fund by an extra 1-2 per cent only to give a comparable return after these deductions.