Even though the markets are at an all-time high, the mood is still one of optimism. Analysts and fund managers are convinced that valuation-wise, the index is still a fair way behind its life-time high.

They believe there could be further upside to the market given the steady growth in the economy and good corporate earnings, estimated at 15-20 per cent for the next couple of years.

There is, however, some concern about whether some stocks and sectors are looking overpriced and whether it is time for a correction.

Given the level of the Sensex today, does it make sense for the retail investor to back an index fund rather than a diversified growth fund?

The argument in favour of index funds is that if Indian markets are indeed moving upwards, then investing in index funds might be a good idea for the risk-averse investor.

It will ensure that the investor captures a reasonable amount of growth. At the same time it also removes the risks associated with several small and mid-cap stocks, which form a good part diversified portfolios and have proved to be a kicker for their returns.

But the apprehension is that diversified funds may not be able to sustain the kind of returns that they have managed so far.

Not everybody agrees. Sandip Sabharwal, head of equities at SBI [Get Quote] Mutual Fund, notes that index funds are not without their drawbacks.

"Index funds suffer from the fact that they are dominated by a few large sectors," he says. Active fund managers quote numbers to prove their point.

Historically, they say, index funds have underperformed diversified funds. For the past five years, diversified funds have given returns of 18.21 per cent compared with 8.47 per cent by index funds.

Even for shorter duration, diversified funds managed to outperform index funds.

According to Sabharwal, in an economy like India's where there are many growth sectors, a top down approach has not succeeded.

"Most fund managers now opt for a bottom-up approach to stock picking so as to be able to cash in on emerging opportunities. That is why a diversified fund tends to perform better," he observes.

According to Suhas Naik, director of equities at ING Vysya Mutual Fund, diversified funds are likely to do better than index funds from here on.

He says, "We have estimated the fair value of the market between 7,300 and 7,500. So we are definitely at the higher end. From here on specific stocks are likely to outperform, which means diversified funds have a better chance than index funds."

In a growing economy like India, the index may not be the barometer for the growth in the economy. "That is because several growth sectors remain under-represented. There are many opportunities especially in the mid-cap segment which are still to be tapped," Sabharwal says.

"Also several companies, which have growth potential, do not find a place in the indices before they have reached a certain size. So investors miss out on the growth phase. Bharti Tele Ventures is a case in point," he adds.

While there is no disputing the merits of diversified funds, for the equity investor who doesn't want to take bigger risks index funds may be the better idea.

"Those who are risk-averse and do not want to bet on a particular fund manager style, but believe that the India growth story will play out in the next few years, can consider investing in index funds," says Naik.

What are index funds?

You may have often heard market participants say Sensex moved up 100 points, lost 150 points and so on. Ever wondered what it actually means?

In just one line, Sensex is an equity-based index, which measures the price movement of a group of stocks listed on the Bombay Stock Exchange.

The basic idea of an index is to capture the mood of the market in a single number to tell how stocks fared on a given day.

An index can be constructed for the overall markets such as Sensex, Nifty and BSE 200 or for a particular sector such as technology, banks among others.

It could also be based on some themes such as growth, value or mid-caps. The difference obviously lies in the choice of stocks based on the objective of the index.

An index fund essentially mimics the index. In other words, the fund manager buys the stocks in the index and also in the same proportion as they are represented in the index. And based on the changes that are made to the index, fund managers also re-align the portfolio of the fund.

Then again, the additional inflows are also invested in a basket of index stocks and in the same proportion. Similarly, when there are outflows in a fund, the fund manager sells in a manner that the fund looks pretty much like the index.

The performance of an index fund could be marginally different from that of the index due to what is called "tracking error" in technical parlance. In some sense, tracking error is a measure of efficiency of index funds.