Index funds are a type of mutual funds that track / replicate a specified benchmark index. The list of indices can range from broad market indices like Nifty 50, Sensex to sector concentrated indices like Nifty Bank, Nifty IT etc.

An index fund tracks / replicates the specified benchmark index of the fund by buying securities comprising the index in the same weightage as that in the index.

A stock market index is a representative of a subset of stock market performance. It helps investors to ascertain performance of the broad stock market by comparing current index levels with previous index levels.

An index is a hypothetical portfolio of securities that represent various segments of the financial markets. Indexes are constructed using pre-defined rules that govern security selection and their weights in the portfolio.

Passive investment options are broadly categorized in two segments: Index Funds and Exchange Traded Funds (ETFs). The underlying principle remains the same for i.e., both track / replicate the specified underlying benchmark index of the fund by investing in securities comprising the index.

The difference between the two options is in the way they are administered. Index Funds are like traditional mutual funds in their administration. Investors can subscribe / redeem units with the AMC at Day end NAV.

Exchange Traded Funds as their name suggest are listed on stock exchanges and are traded like shares. Investors can buy and sell units on the exchange without coming to the AMC directly. AMCs also appoint dedicated market makers for the ETF who provide liquidity for the units on the exchange.

An index fund tracks / replicates the specified index by investing in securities comprising the index constituents in the same weight as the weight of the security in the index.

The index provider calculates the daily weight of the security in the index and releases the file to the AMCs who then use the file to rebalance their portfolio and align it with the index. Any addition / deletion of securities from the index are also intimated to the AMC by the index provider which then takes the necessary steps to buy or sell the respective securities.

• Easy: Easy to understand investment strategy. Tracking or replicating a pre-specified benchmark/index as closely as possible.
• Rule Based Investing: An index is a rule-based portfolio with stock/company selection based on pre-defined rules and free from any individual biases.
• Efficient: Portfolio reflecting the collective wisdom of the market with market performance subject to tracking error and expenses.
• Economical: Generally lower expense ratio than an active mutual fund due to no active involvement of the fund manager in investment decision.
• No Style Drift: A style drift is when a fund manager makes investment that are outside the fund’s defined investment style. For example, a large cap fund investing in small caps. Style drifts change the risk structure of the fund which the investor may not have signed up for but is exposed to, nonetheless. Index funds are by regulation required to strictly replicate the index with no active decision in security selection by the fund manager.

There is no active stock selection or investment decision requirement to be made by the fund manager in an index fund. This eliminates the time involvement of the fund manager and the research requirements. Additionally, index funds tend to have less portfolio churn as compared to active funds resulting in saving on transaction costs. These costs which forms major portion of a fund’s expense ratio are eliminated resulting in index funds having a relatively low expense ratio.

Index funds are an easy, efficient, and economical investment instrument catering to all types of investors. New investors may benefit considering the easy-to-understand structure along with relatively low costs and diversification benefits that an index fund offers. Experienced investors may benefit from using index funds in a core satellite portfolio construction approach with the bulk of their portfolio (core) in broad market index funds and the remainder portion (satellite) in riskier investments.

Tracking difference is the difference in the return generated by the index fund and the returns generated by the underlying index. For example, if Nifty 50 has generated a return of say 10% in a year and the index fund tracking the index has generated a return of 9.5% in the same period, the tracking difference of the fund is 0.5%.

Tracking error is a measure of deviation of fund returns from the benchmark returns. Unlike tracking difference which computes point to point returns and highlights difference of returns between fund and index, tracking error calculates standard deviation of daily difference in performance between the fund and index and highlights the annualized number which is known as tracking error.

Tracking error is the mark of efficiency and consistency of an index fund with it indicating how closely the fund manages to track / replicate the index. A lower tracking error indicates the fund is consistent in replicating its portfolio with that of the index whereas a higher tracking error points to inconsistencies in benchmark tracking / replication.

The main sources of tracking error and tracking difference are as follows:

• Fees and expenditure incurred by the scheme.
• Cash held by the scheme due to subscriptions or to meet redemptions, expenses etc.
• Corporate Actions.
• Unavailability of securities in the underlying index due to circuit filters, lack of liquidity.
• Halting of trading in underlying securities by the exchange.
• Delay in replicating the portfolio during times of high volatility and reconstitution / rebalancing of the index.
• Rounding off securities for buying or selling as compared to the underlying index.
• Methodology of calculation of settlement price of the index. The benchmark or underlying index reflects the Volume Weighted Average Price (VWAP) of securities in the last half hour. However, the scheme may buy and sell at different points in time during the trading session at the then prevailing prices which may not correspond to the closing prices on the exchange.

One can invest in an index fund in a similar way to normal mutual funds i.e. by submitting the application form online or in physical to the AMC. Also, one may contact their distributor or relationship manager for investing in an index fund as well. Finally, one can use the latest fintech platforms for investing in an index fund.

The major risks associated with index funds remain the same as with any traditional mutual funds investing in the same asset class. All equity funds including equity index funds will be subject to the same risk and same goes for debt index funds. Additional risks involved with index funds include the following:

• Tracking Error
• Tracking Difference
• Index related risk – Concerning rules for inclusion/exclusion of securities, maintenance of index etc.
• Index Dissolution Risk
• Management risk wherein the fund may not be able to fully replicate the index.
• Concentration risk
• Passive investment risk wherein the fund manager has to make the investment in the securities comprising the underlying index regardless of their investment merit.

Investors are requested to read the Scheme Information document for detailed information on the risk factors of the scheme.

Index funds are taxed basis the asset class that they invest in. Equity index funds will be taxed as per equity taxation and debt index funds will be taxed as per debt taxation. Investors are requested to read the Scheme Information document before investing.