With the market climbing above 12,0000 levels, the NAVs of most equity funds are looking better than before. However, many investors are realizing that some of the funds in their portfolio have not been able to keep pace with the market. While it may have surprised new investors, most seasoned investors know that this is a normal phenomenon.

In other words, it is an established fact that different funds react differently at a time when the market is on its way up and when the market is on its way down.

It's all about the portfolio composition of the scheme i.e. the quality of the portfolio as well as exposure to different market segments that influences the level of fall and rise in the NAV. Since actively managed funds have varying degree of exposure outside index, the impact of its movement on the NAVs differs from fund to fund.

No wonder, some funds that react slowly during the initial phase of the recovery in the market, outperform others as the rally spreads to all the segments of the market. (Also read - 7 investment tips to improve your returns)

The moot question, therefore, is whether it is possible for investors to ensure that their portfolios move in line with the market. Index funds are, at times, projected as an answer to this need of certain section of investors. Considering that Index funds have been doing well on one year basis, I am sure many investors must be wondering as to why these funds should not be a part of their portfolio.

Before we analyse as to whether Index funds merit inclusion in every investor's portfolio or not, let us first understand what an Index fund is and how does it differ from actively managed funds.

An index fund is a type of passively managed fund that seeks to track the performance of a benchmark market index like BSE Sensex or S&P CNX Nifty. To achieve this intended result, the fund maintains the portfolio of all the securities in the same proportion as in the benchmark index. The offer document of an index fund clearly states as to which index the fund would track.

The major advantage of investing in an index fund is that one knows exactly the shares the fund would invest in. Besides, for an individual investor, it is practically impossible to create a portfolio that matches an index fund portfolio. The downside of investing in an index fund is that one forfeits the possibilities of earning above average returns that a good quality diversified fund may be able to provide over the longer term. (Also read - Learn how to tackle risk through diversification)

Index funds differ from an actively managed diversified fund in that trading is done not in an effort to sell non-performing securities and buy the better performing ones but to mimic a changing index and to deal with fresh inflows and outflows on account of redemptions.

Let us now analyse as to how index funds generally perform vis-�-vis actively managed equity funds. In a rising market, vast majority of actively managed funds under-perform the index funds. However, over the longer term, most actively managed funds out-perform the index funds. This happens because actively managed funds may hold superior stocks that perform better than the average and the fund manager may ride the upswing and miss the falls by actively managing the portfolio.
 
If we analyse the current performance data, Index funds have given an average return of 41.4 per cent on one year basis as against an average of 35.55 per cent given by actively managed funds during the same period.

However, the picture is very different over the longer term. Index funds managed to give a return of 39.58 per cent and 34.14 per cent as against 48.71 per cent and 46.15 per cent given by actively managed funds over three year and five-year period respectively. (Also read - How to build your MF portfolio?)

Though Index funds provide an inherent advantage to investors as they are charged lower expenses compared to actively managed funds, not many are able to enjoy this benefit as the holding period of Index fund investors is generally much shorter than that of investors in actively managed funds.

Besides, the ability to move in and move out gives an active fund manager a great advantage over a passively managed fund. Considering that index funds are effectively run by computers and the fact that price sensitive information keep appearing regularly, the actively managed funds have to be the mainstay of a long term investor's portfolio.

Never mind the little extra that one has to pay to an active fund manager. One needs to give one's investments a chance to out-perform the market and a portfolio of good quality funds can achieve that over the longer term.

However, for an investor who does not monitor his portfolio regularly, a blend of active and passive funds can be a good strategy. However, before investing money in an index fund, one has to be careful about the selection of the index.

While the right way to decide on the portfolio composition depends on each investor's time horizon, risk profile and the size of the portfolio, as a thumb rule the portfolio can be indexed to the extent of 15-20 per cent. In fact, mutual fund investors also have the advantage of investing in "enhanced index funds" i.e. funds that seek to slightly out-perform a specific index while maintaining an overall risk profile comparable to the index.

The author is CEO, Wiseinvest Advisors Pvt. Ltd. He can be reached at hemant.rustagi@moneycontrol.com

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