Index funds vs diversified funds - Ways to beat market

The steep decline in the equity market in 2008 has wiped out a large part of investors’ wealth, irrespective of whether they took the direct investment route or went through mutual funds. In a volatile market such as the present one, predicting short-term movements and timing the market, despite the steep corrections already witnessed, remains a challenge. 

In uncertain times investing through index funds may be a better option if one prefers to go with the market tide. The one-year return clocked by the index funds is between -41.5 and - 47.5 per cent, as against BSE Sensex and S&P Nifty decline of 54.7 per cent and 54.3 per cent respectively. 

The divergence between the benchmark performance and the index funds is due to tweaking of the portfolio with minor changes in the weight of stocks held and cash position of the funds. During the same period diversified funds have declined in the range of 34-74 per cent.

Index funds are passively managed funds and mirror the index by holding the index stocks in similar proportions. Being passively managed, index funds have lower expenses than diversified funds. On the other hand, active calls taken by diversified funds can work against them in unpredictable markets in the short-term, resulting in higher declines. 

Diversified fund managers tend to take aggressive or contrarian strategies to outpace their respective benchmarks. Over bullish phases an active fund manager seeks to score a high beta over the benchmark, while also generating consistently superior risk-adjusted returns (called alpha) over the long term. 


Over three- and five-year periods, diversified funds outpaced the index funds by a huge margin. Magnum Contra, an open-ended diversified fund with a good track record, generated a compounded annualised return of 31 per cent over five-year period and outpaced the HDFC Index Fund Sensex Plus Plan by 16 percentage points. However, these funds have outpaced the benchmark BSE Sensex and S& P CNX Nifty over the same time-frame. 

Selecting an index fund requires less effort than choosing a diversified fund. An individual can choose a Sensex or Nifty fund based on his/her risk appetite. However, in diversified funds one has to look out for various aspects such as the fund’s long-term track record, investment style and objectives, along with the fund manager’s ability to produce positive alpha.