What is the benefit of mutual funds beating the index to a common man?

Published: September 13, 2021 at 8:45 am

Last Updated on September 13, 2021 at 8:45 am

A viewer on our YouTube channel asks, “What is the benefit of a mutual fund beating the index? How it is going to benefit a common investor?” On the face of it, this seems like the answer is obvious, but that is not true because of how the real cost of investing in a mutual fund is packaged.

This question can be rephrased differently: “As long as I get returns, how does it matter whether I buy active funds or passive funds, direct plan funds or regular plan funds.”

Consider a bar of soap costing Rs. 50. We rarely think about the different players involved, from the manufacturer to the merchant and their profit margins. Suppose the cost of manufacturing one bar is Rs. 5. For the soap to reach the “common man”, at least two “intermediaries” are necessary.

A wholesale network should buy the bars in bulk from the manufacturer and sell them to retail merchants. The manufacturer sells it to the wholesaler for Rs. 20 for a profit of Rs. 15. The wholesaler sells it to the retailer for Rs. 35 for a profit of Rs. 15. The retailer sells it to us for Rs. 50 for a profit of Rs. 15 (excluding taxes).

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥

Just because we are not directly paying the manufacturer and wholesaler does not mean they don’t get paid! Now, how is all this relevant to mutual funds? The NAV that gets published every day is equivalent to the price of soap. The NAV of a mutual fund deducts the total expense ratio of a mutual fund daily before publication.

The amount deducted in an actively managed fund is at least five times higher than a passively managed fund (index fund or ETF). In a regular plan MF (active or passive), the amount deducted is higher because commissions need to be paid to the sales guys (intermediaries).

First, let us confine ourselves to the active vs passive fund debate.  You buy a bar of soap in a local shop or online. You open it, and it is half-used and all squished up. What would you do? Tell yourself, “I asked for a soap bar and got one. Does not matter the state it is in”, or would you seek a replacement or a refund?

Now, let us cut to workplace bonuses. You work tirelessly 20 hours a day for a whole year; finish your products flawlessly and well before time, but get the same amount of bonus as employees who put in half your effort. How would you feel? Would you shrug it away, thinking, “all employees should be rewarded the same?”

If you wonder how this is all related to mutual funds, consider how active mutual funds operate. Suppose an active mutual fund underperforms a benchmark like the Nifty. Do they refund us a portion of the management fee? Do we get compensated in any way for placing our hard-earned money in a product (managed by experts) that has failed to beat a basket of stocks that any one of us can put together by simply looking at market capitalization?

We ask for a refund or replacement when a bad product has been delivered; we feel aggrieved if our efforts are not appreciated and consider employment elsewhere. Then should we happily accept a fund manager getting paid at least five times more for failing to beat the index?

An active mutual fund has only one objective. It costs more for only one reason. The fund house claims they have what it takes to beat a benchmark. They may not refund* management fees if they fail but should we happily accept underperformance at a higher cost? Who do you think is paying the extra cost? The common man or someone else?

* A fund that does this would be a good idea, but the industry is unlikely to bite.

The primary reason for choosing passive funds or index funds should not be the cost. We have reported time and time again that only about half the number of active funds in any category have managed to beat representative benchmarks. This means your five-star rated “best fund” will not remain so for long. See, for example, Four consistent midcap mutual fund performers.

Trying to remain invested in the best funds at all times would be like trying to chase our own tails. It may get some returns but at what cost? Just because we do not see the pre-expense NAV does not mean the costs are absent!

The situation with regular plan funds is worse. Even today, many distributors claim, investors can buy regular plan funds for free, and the distributors are compensated separately by the fund houses. This is like saying the cost of soap is Rs. 50 to you, but you do not pay my profit margin; someone else does.

Again the primary reason for choosing direct plan funds should not be the cost. SEBI has made it quite clear that distributors should not provide investment advice. Then there is the conflict of interest. Why would you ask a barber if you need a haircut?!

So, What is the benefit of mutual funds beating the index to a common person? The high cost that the commoner pays to an active fund manager is justified only if they manage to outperform a simple index or at least an index fund.

Sure the common person only wants some good return. If this can be obtained at a low cost, it is obviously the better choice. If this can be obtained by getting rid of an intermediary (sales guys in regular plans) and conflict of interest for guaranteed higher returns (relative to regular plans), it is obviously the better choice. Time for the common investor to put on a thinking cap.

Do share this article with your friends using the buttons below.

🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 5000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! More than 1,000 investors and advisors use this!
New Tool! => Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
Follow Freefincal on Google News
Follow Freefincal on Google News
Subscribe to the freefincal Youtube Channel. Subscribe button courtesy: Vecteezy.
Subscribe to the freefincal Youtube Channel.
Follow freefincal on WhatsApp Channel
Follow freefincal on WhatsApp
Podcast: Let's Get RICH With PATTU! Every single Indian CAN grow their wealth! 
Listen to the Lets Get Rich with Pattu Podcast
Listen to the Let's Get Rich with Pattu Podcast
You can watch podcast episodes on the OfSpin Media Friends YouTube Channel.
Lets Get RICH With PATTU podcast on YouTube
Let's Get RICH With PATTU podcast on YouTube.
🔥Now Watch Let's Get Rich With Pattu தமிழில் (in Tamil)! 🔥
  • Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
  • Have a question? Subscribe to our newsletter using the form below.
  • Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.

Join over 32,000 readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email!

About The Author

Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!   
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both the boy and girl-version covers of "Chinchu Gets a superpower".
Most investor problems can be traced to a lack of informed decision-making. We made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, what would it be if we had to groom one ability in our children that is key not only to money management and investing but to any aspect of life? My answer: Sound Decision Making. So, in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parents plan for it, as well as teaching him several key ideas of decision-making and money management, is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)