Why index funds beat most active funds, as arithmetic

The arithmetic

All the investors in a market collectively own the market. So collectively, before costs, they earn exactly the market return. That is not a claim about skill, it is a definition.

Split them into two groups: those who simply hold the market, and those who try to beat it. The first group earns the market return, minus a very small fee, by construction.

Which means the second group, in aggregate, must also earn the market return before costs. There is nowhere else for the return to come from. And after costs, which are substantially higher for that group, the average actively managed rupee must earn less than the market.

How big the gap is

This is the part you can check before investing rather than after.

Under the SEBI (Mutual Funds) Regulations, 2026, index funds and ETFs are capped at 0.90%, and competitive direct plan index funds charge a fraction of that. Active equity funds sit meaningfully higher.

Say the difference is 1.3 percentage points a year. An active fund has to beat the index by 1.3 points every year simply to draw level. Not once. Every year, indefinitely, net of its own trading costs.

Compounded over decades against a growing balance, that is a large handicap to overcome before adding any value at all.

The harder problem: picking in advance

Suppose you accept that some managers beat the index. You still have to identify them before they do it, not afterwards.

The usual method is past performance, which is a weak guide. Funds near the top of a table frequently drift toward the middle within a few years, because the market conditions that suited their style change. And a record built by a manager who has since left is not a record of anything you can buy.

An index fund removes that question entirely. There is no manager to be right or wrong, no style to fall out of favour, and no key person to depart.

The honest arguments against

Index funds are often sold with more enthusiasm than accuracy. Here is the other side, stated properly.

• They offer no protection in a fall. If the Nifty drops 35%, your Nifty index fund drops about 35%. No manager steps aside.
• Indian indices carry real concentration. The Nifty 50 is heavily weighted toward financials. An index fund is diversified across companies, not evenly spread across sectors.
• Less efficient markets may reward active management more. The arithmetic still holds in aggregate, but the dispersion of manager outcomes can be wider, and a genuinely skilled manager has more room.
• Index does not mean safe. A small cap index fund is an index fund and can still fall by half.
• Someone has to do price discovery. If everyone indexed, prices would stop reflecting anything. Index investors are, in a sense, free riding on active investors doing that work.

Where this leaves a beginner

The arithmetic is not a reason to believe index funds are magical. It is a reason to treat them as the default, and to require a specific argument before paying more.

That argument might be perfectly good: a manager whose approach you understand, in a segment where you think skill matters, at a cost you have looked at. The point is that it should be an argument, not an assumption.

And the two numbers worth comparing between index funds themselves are the expense ratio and the tracking error. Last year return tells you almost nothing between two funds tracking the same index.

Full detail in index funds.