Index funds have become one of the simplest ways for Indian investors to get stock market exposure without picking individual stocks or fund managers. They follow a market index, keep costs low and are easy to understand. This beginner’s guide to index funds in India explains how they work, what tracking error and expense ratio mean, and how an index fund differs from an ETF.
Key takeaways
- An index fund copies a market index, such as the Nifty 50, instead of trying to beat it.
- SEBI requires index funds to invest at least 95% of their assets in the securities of the index they track.
- Tracking error shows how closely a fund follows its index; lower is better.
- Low expense ratios are a major advantage of index funds, and small cost gaps compound over time.
- ETFs track indices too, but trade on the stock exchange and need a demat account.
- Index funds carry full market risk; they fall when the index falls.
What is an index fund?
An index is a basket of stocks that represents a part of the market. The Nifty 50, maintained by NSE Indices, represents 50 large companies listed on the National Stock Exchange, weighted by free-float market capitalisation. You can see its current constituents on the Quantsgrow Nifty 50 stocks list.
An index fund is a mutual fund that buys all the stocks in an index, in the same proportion. If a company makes up 10% of the index, it makes up roughly 10% of the fund. There is no stock selection by a fund manager. This approach is called passive investing.
For a deeper look at how the Nifty 50 itself works, read our Nifty 50 index explained guide.
How index funds work in India
Under SEBI’s mutual fund categorisation framework, index funds fall under “Other schemes” and must invest at least 95% of total assets in the securities of the underlying index. The process is simple:
- You invest money, through a lumpsum or a SIP.
- The fund buys the index stocks in their index weights.
- When the index provider rebalances the index, for example during periodic reviews, the fund adjusts its holdings.
- Your returns follow the index, minus the fund’s expenses and small tracking differences.
Indian index funds track many indices, including the Nifty 50, Sensex, Nifty Next 50, mid cap and small cap indices, sector indices and some debt and international indices. Browse the category on the Quantsgrow index funds page.
Why investors choose index funds
- Low cost: no expensive research team, so expense ratios are usually lower than active funds.
- Transparency: you always know broadly what the fund holds.
- No manager risk: you will not underperform the index because of poor stock picking, apart from costs and tracking error.
- Diversification: one fund gives exposure to many companies.
- Simplicity: easy to understand and easy to compare.
Tracking error and tracking difference
No index fund matches its index exactly. Two measures tell you how close it gets.
Tracking difference
Tracking difference is the gap between the index return and the fund return over a period. If the Nifty 50 Total Return Index gained 12.0% in a year and the fund gained 11.8%, the tracking difference is 0.2 percentage points. It mainly reflects expenses and cash holdings.
Tracking error
Tracking error is the annualised standard deviation of the difference between the fund’s daily returns and the index’s daily returns. It measures consistency. A fund can have a small tracking difference but a high tracking error if its daily returns wobble around the index.
SEBI’s May 2022 circular on passive funds requires that tracking error for index funds and ETFs, based on one-year rolling data, should not exceed 2% (subject to exceptions set out in the circular). Fund houses must disclose tracking error and tracking difference on their websites and in factsheets.
What causes tracking error?
- Expense ratio charged by the fund.
- Cash held for redemptions, which does not move with the index.
- Timing gaps when the index changes and the fund rebalances.
- Corporate actions and dividends being received and reinvested with a delay.
- Transaction costs from buying and selling stocks.
Why expense ratio matters so much
Since all index funds tracking the same index hold the same stocks, costs become a key difference. A small gap compounds over long periods.
Here is a hypothetical example, for illustration only. Suppose you invest ₹10,00,000 for 20 years:
- At 11% per year after costs, it grows to about ₹80.62 lakh.
- At 10% per year after costs, it grows to about ₹67.27 lakh.
A one percentage point difference in net return, which could come from higher costs, reduces the final corpus by about ₹13.35 lakh. You can run your own numbers with the Quantsgrow lumpsum calculator.
SEBI sets a lower maximum total expense ratio (TER) for index funds and ETFs than for actively managed equity funds. Check the scheme’s latest TER in its factsheet, and note that direct plans cost less than regular plans.
Index fund vs ETF
Exchange traded funds (ETFs) also track an index, but they work differently in practice.
| Feature | Index fund | ETF |
|---|---|---|
| How you buy | From the fund house or an MF platform | On the stock exchange (NSE or BSE) |
| Price | End-of-day NAV | Live market price during trading hours |
| Demat account | Not required | Required |
| SIP | Easy, supported by all fund houses | Possible via some brokers, not standard |
| Costs | Expense ratio only | Expense ratio plus brokerage and bid-ask spread |
| Typical expense ratio | Low | Often lower than index funds |
| Liquidity risk | Fund house redeems units at NAV | Depends on trading volumes; low-volume ETFs may trade away from NAV |
| Best suited for | Investors who want simple SIPs | Investors comfortable with exchange trading |
How to choose an index fund
- Pick the index first. A Nifty 50 fund gives large cap exposure; a Nifty Next 50 or mid cap index fund carries more volatility.
- Compare expense ratios among funds tracking the same index.
- Check tracking error and tracking difference over at least one year.
- Look at fund size. Very small funds may have higher tracking error.
- Check exit loads and minimum investment amounts.
- For ETFs, check trading volume and how close the market price stays to NAV.
To learn how large and smaller company indices differ in risk, see our guide on large cap vs mid cap vs small cap funds.
Tax on index funds
Equity index funds that hold at least 65% in domestic equity are taxed as equity-oriented funds. After Budget 2024 (effective 23 July 2024):
- Short-term gains (held up to 12 months): 20%.
- Long-term gains (held over 12 months): 12.5% on gains above ₹1.25 lakh per financial year.
Debt index funds and international index funds may be taxed differently. Confirm the latest rules on the Income Tax Department website.
Common mistakes beginners make
- Assuming index funds are risk-free. They fall with the market.
- Choosing a fund only for the lowest expense ratio, while ignoring tracking error.
- Buying multiple funds tracking the same index, which adds nothing.
- Buying illiquid ETFs and paying a high premium to NAV.
- Confusing a narrow sector index fund with a broad market index fund.
- Stopping SIPs when markets fall.
An index fund aims to give you the market’s return, minus a small cost. Its biggest strengths are low cost and discipline, not the ability to avoid market falls.
Conclusion
Index funds in India offer a low-cost, transparent and simple way to invest in the stock market. Understanding tracking error, expense ratio and the difference between index funds and ETFs will help you compare options sensibly. Remember that an index fund still carries the full risk of the index it tracks.
To explore further, open the free Quantsgrow app, compare schemes on the index funds page and check what makes up the index on the Nifty 50 stocks list. You can also estimate long-term growth with the SIP calculator.
Frequently Asked Questions
What is an index fund in simple words?
An index fund is a mutual fund that copies a market index, such as the Nifty 50 or the Sensex. Instead of a fund manager choosing stocks, the fund buys the same companies in the same proportion as the index. Its aim is to deliver returns close to the index, minus costs, rather than trying to beat the market.
What is tracking error in an index fund?
Tracking error measures how consistently a fund’s daily returns follow its index. Technically, it is the annualised standard deviation of the difference between the fund’s returns and the index’s returns. A lower tracking error means the fund mirrors the index more closely. SEBI requires fund houses to disclose tracking error and has set an upper limit for it.
Is an index fund better than an ETF?
Neither is better for everyone. Index funds are bought from the fund house at end-of-day NAV, need no demat account and support SIPs easily. ETFs trade on the stock exchange during market hours, need a demat and trading account, and may have lower expense ratios but involve brokerage and bid-ask spreads. The choice depends on convenience, costs and liquidity.
Can an index fund lose money?
Yes. An index fund falls when its underlying index falls, because it holds the same stocks. A Nifty 50 index fund will decline in a market correction just as the Nifty 50 does. Index funds remove the risk of a fund manager underperforming the index, but they do not remove market risk. They are still subject to market volatility.
How are index funds taxed in India?
Equity index funds that hold at least 65% in domestic equity, like Nifty 50 index funds, are taxed as equity-oriented funds. After Budget 2024, short-term gains on units held up to 12 months are taxed at 20%, and long-term gains above ₹1.25 lakh per year are taxed at 12.5%. Debt or international index funds may be taxed differently, so check the Income Tax Department website.
Disclaimer
This article is for educational purposes only and is not investment advice. Quantsgrow is not a SEBI-registered investment adviser, and all examples and returns used are hypothetical and for illustration only. Please consult a SEBI-registered investment adviser before making any investment decision. Mutual fund investments are subject to market risks; read all scheme-related documents carefully.
