Index funds were launched with a lot of fanfare, like a lot of other products that are 'imported' from developed financial markets.

They were considered as a cost-effective investment option to actively managed diversified equity funds for their ability to provide index-linked returns at a lower cost. But has this premise translated into results? Let us find out.

First let us understand how index funds work. Index funds invest in a basket of predefined stocks of an index (like the BSE Sensex or S&P CNX Nifty) in an allocation that resembles that of the benchmark index.

That is why index funds are also referred to as passively managed funds. This is different from how actively managed funds function; they also have a benchmark index but make active stock and sector calls in their bid to outperform the index.

This is the primary difference between passive funds and active funds; one is content at giving index-linked returns, while the other consciously tries to outperform it.

In their attempt to outperform the index, active funds diverge from index funds on two important counts -- volatility and expenses. Lets take volatility first -- when active funds invest outside the index they take on stock and sector risk that are usually higher than risks associated with an index fund. This reflects by way of a higher turbulence in performance vis-�-vis index funds.

The other factor on which active funds witness a departure from index funds is on expenses. And again this is related to active funds trying to outperform index funds by clocking above-average growth.

The average active fund buys and sells stocks a lot more than an index fund. This results in a higher portfolio churn, which in turn has a direct bearing on expenses. So active funds have a higher expense ratio than index funds.

So, as far as index funds are concerned, lower expenses and index-linked returns are the biggest draws for the investor. However, while returns have been index-linked after accounting in tracking errors, lower expenses are an unfulfilled promise with most index funds.

It is not that index funds in India have high expenses, its just that they are not low enough to get investors interested. Typically, what should be the magnitude of difference in expenses between index funds and active funds?

To answer that question lets look at a developed mutual fund market like the US where index funds are extremely popular for being cost-effective.

It is evident why index funds have such a fan following in the US. When you have expense ratios in the region of 0.10%-0.20% of net assets and your returns are aligned to the index, which active funds in any case struggle to outperform, you have plenty of reasons to invest in index funds.

Cost-consciousness in fund management is an important trait in the US. Sample this, Fidelity's website mentions that it 'has contractually limited Fidelity Spartan 500 Index's total annual fund operating expenses (except interest, taxes, brokerage commissions, securities lending fees, or extraordinary expenses), as a percentage of average net assets, to be 0.10%.'

This means expense limit cannot be increased beyond the 0.10% limit without approval of the fund's shareholders and board of trustees.

But that is in the US; in India index funds have a long way to go before they can be considered inexpensive. Although, index funds are cheaper than their actively managed counterparts, the difference is not significant, which partly explains the lukewarm investor response.

It is apparent from the table that index funds in India have a lower expense ratio vis-�-vis their actively managed peers. Also apparent is that they aren't as cost-effective as their US counterparts when you begin comparing them to their actively managed counterparts from the same fund house.

Take FT India Sensex, with a low 1.00% expense ratio, it is still relatively high compared to Franklin Bluechip's 1.90%. Likewise, HDFC Sensex's expense ratio (1.50%) isn't that competitive when you consider that HDFC Equity's expense ratio is 2.02%.

In fact, HDFC Sensex expense ratio does not even compare favourably to HDFC Sensex Plus' expense ratio (1.50%), despite the fact that the latter has an element of active fund management to the extent of 20% of net assets.

If one looks at the index funds from the two fund houses we have selected - HDFC Mutual Fund and Franklin Templeton; at expense ratios of 1.50% and 1.00% (respectively), the disparity is too sharp, for the same fund management style. HDFC Mutual Fund's index funds are too expensive.

Of course, one has to also consider the fact that in India, many actively managed funds comfortably outperform the index over longer time frames (over 3 years). This is because unlike the US, India is a developing economy and many stocks are still under-researched.

This gives fund managers several investment opportunities to outperform the index. So investors chasing performance still have a good reason to invest in active funds. However, investors chasing lower costs do not have a good enough reason to invest in index funds.

In our view, index funds need to urgently address the issue of lower costs, because this can make a considerable difference to the total returns over a period of time.

This way index funds can be considered by cost conscious, medium risk investors; because even if their performance lags that of active funds, they can still manage to add a few percentage points of growth by way of lower costs.

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