Index funds have been gaining investor attention in the recent times, thanks to the underperformance of many actively managed large-cap funds against their benchmarks such as the Nifty 50 TRI and the Nifty 100 TRI.

The move towards TRI-based (Total Return Index) benchmarking, SEBI’s reclassification norms that standardised allocations in each category, and choppy market conditions were some reasons for the underperformance of actively managed funds.

Passively managed funds

Index funds are passively managed mutual funds that try to replicate the performance of their underlying benchmarks. They imitate the portfolio of an index (say the Nifty 50) by investing in stocks that are a part of it in the same proportion as they are in the index.

Here, we look at index funds that track the Nifty 50 Index as the benchmark.

Currently, there are 14 Nifty 50 index funds available in the market.

Nifty 50 index funds invest in stocks that are part of the Nifty 50 index, in the same proportion as they are in the index.

They aim to achieve returns commensurate with Nifty 50 index returns.

The Nifty 50 is a diversified index that reflects, to a certain extent, the overall market conditions of the Indian equity market. By buying a unit of the Nifty 50 index fund, investors can diversify their portfolio with 50 stocks across 13 broad sectors.

As there is no active selection of stocks by the fund manager, unsystematic risk (risk pertaining to selection of companies, sectors, etc) in index funds is low. Also, these funds invest only in large-cap stocks wherein the liquidity is higher and risk of volatility is lower. Sub-optimal stocks based on market capitalisation, trading volume and value will not be included in the index as they are reshuffled at regular intervals.

As index funds do not actively select the stocks, their expense ratios are lower than the actively managed equity funds.

Nifty 50 Index funds can be a preferred option for investors who want Nifty 50-linked returns. Investors new to the equity market can also consider opting for this route.

Tracking error

Over the short and long term, index funds that track the Nifty 50 index as the benchmark, have delivered returns commensurate with the Nifty 50 index returns.

Over one-, three- and five-year time-frames, these funds, on an average, delivered compounded annualised returns of 14 per cent, 15.6 per cent and 8.7 per cent, respectively.

Apart from returns, the efficacy of index funds is identified through tracking error (TE), which measures how closely an index fund tracks its chosen index. In simple words, TE is the difference in returns between an index fund and its benchmark.

Index funds with lower TE are the preferred choices.

TEs calculated from the last one-year NAV history show that they were in the 0.001-0.13 per cent range.

UTI Nifty Index, HDFC Index Fund-NIFTY 50, IDBI Nifty Index, and Tata Index Fund have shown lower TEs over the past year.

Index funds versus ETFs

Exchange-traded funds (ETFs), the other variant, are also passively managed mutual funds traded on BSE and NSE.

Currently, 16 ETFs track the Nifty 50 Index as the benchmark.

Index funds score over ETFs on various counts. First, liquidity has been a major issue when trading in ETFs.

But index funds are directly bought and sold from the AMC, hence liquidity would not be an issue.

Demat and broker accounts are mandatory while transacting in ETFs on the exchange.

But, buying an index fund is like buying any mutual fund, and does not need a demat account. A systematic investment plan (SIP) is not allowed in ETFs, but it is allowed in index funds.

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