Index Funds Decoded

Understand tracking errors, management costs, and associated risks for informed investing

Neeraj Saxena, Fund Manager & Dealer – Equity Baroda BNP Paribas Mutual Fund

• What are Index Funds?

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. 

• What is an 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.

• How does an index fund work?

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. 

• What are benefits of index funds?

• 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: Index funds are by regulation required to strictly replicate the index with no active decision in security selection by the fund manager.

• Why do index funds have low management cost?

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.

• Who should invest in index funds?

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 to gain the desired market cap exposure or exposure to certain index strategies.

• What is tracking error?

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.

• How to invest in an index fund?

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.

• What are risks associated with Index funds?

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:

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

• How are index funds taxed? 

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.