Index Funds in India: How Tracking Works and Where It Goes Wrong
An index fund has one job: own the index. That makes it the easiest kind of fund to describe and the hardest to evaluate, because once you remove the question of whether the manager is any good, the only things left are small and technical — and they are the only things that distinguish one NIFTY 50 fund from another.
This chapter is about those small things: what the fund is actually required to do, the two different numbers that measure how well it does it, and the four structural reasons it never does it perfectly.
What the fund is contractually doing
A SEBI-regulated index fund is an open-ended scheme whose stated objective is to replicate a specified index. Under SEBI’s categorisation rules, it must hold at least 95% of its net assets in the securities of that index.
That 95% floor is the whole design. It is not a target the manager aims at — it is a constraint the manager is bound by. There is no discretion to overweight a stock the manager likes or exit one they dislike. If a stock is in the index at a 4.1% weight, the fund holds roughly 4.1% of it, whatever the manager thinks.
The remaining headroom exists for cash management: meeting redemptions, holding inflows briefly before deployment, and holding margin for any derivative positions used to equitise cash.
Tracking error versus tracking difference
These two are routinely confused, including in fund marketing, and they measure genuinely different things.
Tracking difference is simple: fund return minus index return, over a period. If the NIFTY 50 returned 12.4% and the fund returned 12.0%, the tracking difference is −0.4%. It tells you how much you actually gave up. It is the number that affects your wealth.
Tracking error is the standard deviation of the daily return differences, annualised. It measures how consistently the fund tracks, not how closely. A fund that lags the index by exactly 0.03% every single day has a large tracking difference accumulating over a year and a tracking error of almost zero.
So:
| What it measures | What a low number means | |
|---|---|---|
| Tracking difference | Total shortfall vs the index | You kept more of the index’s return |
| Tracking error | Day-to-day consistency of the gap | The gap is predictable, not necessarily small |
SEBI requires index funds to disclose tracking error on the AMC website and in scheme documents. Tracking difference is the one worth checking yourself, and it is derivable from the fund’s own disclosed returns against the index’s total return figures.
The distinction matters because a fund can advertise a low tracking error while consistently losing to the index — the consistency is precisely what makes the loss reliable.
The four reasons a fund drifts
1. The expense ratio
This is the largest and most predictable drag. An index fund charging 0.20% will, all else equal, return about 0.20% less than the index per year. It cannot do otherwise; the fee comes out of the NAV daily.
Indian index funds span a wide range here, and because every other difference between two NIFTY 50 funds is small and partly random, the expense ratio is the one input that reliably predicts the ranking of their long-run returns. Our guide to the expense ratio covers how it is charged and how to find a scheme’s current figure.
2. Cash drag
A fund receiving an inflow on Monday cannot always be fully invested by Monday’s close. During the gap, that money is in cash — earning overnight rates while the index moves.
In a rising market, cash drag costs you. In a falling market, it helps. On average it is a small negative, because equity indices rise more often than they fall, but it also adds noise, which shows up as tracking error rather than consistent tracking difference.
Some funds equitise cash with index futures to reduce this. That works, and introduces its own basis risk and roll cost.
3. Rebalancing costs
When the index changes — a stock is added, another removed, free-float weights are revised — the fund must trade. It cannot choose not to.
This is the point of maximum vulnerability for a passive fund, because everyone tracking that index must trade the same stock in the same direction on the same day. The index provider announces changes in advance; the market front-runs them. The fund buys the incoming stock after it has already been bid up and sells the outgoing one after it has been pushed down.
The larger the fund, the harder this gets, and the larger the index’s turnover, the more often it happens. A NIFTY 50 fund rebalances rarely. A fund tracking a smallcap or thematic index rebalances far more, and pays each time.
4. Corporate actions and dividends
When a constituent announces a dividend, a bonus or a split, the index is adjusted on the ex-date by a formula. The fund holds real shares and receives real cash.
Index values are usually quoted on a total-return basis for benchmarking, which assumes dividends are reinvested instantly at the ex-date price. A fund receives the dividend days later and reinvests it then, at whatever price prevails. Our pages on bonus issues and stock splits and dividend record dates cover the mechanics of these adjustments.
Then there is tax. A fund pays no tax on dividends received — equity schemes are exempt at the fund level — but it does pay STT on its own rebalancing trades, at 0.1% each side, and that is a real cost the index does not bear. Our STT guide has the rates.
Index funds versus index ETFs
Both track an index. The difference is how you transact.
An index fund is bought and sold at NAV, computed once at the end of the day. Your order executes at a price nobody knows when you place it, and there is no bid-ask spread.
An ETF trades on the exchange through the day. You see the price before you trade, and you pay a bid-ask spread plus brokerage. In India this matters more than in deeper markets, because many Indian ETFs trade thinly — spreads widen, and the market price can sit away from the underlying NAV for stretches.
For a monthly SIP, an index fund is usually the less frictional instrument. For a single large allocation where you want price certainty, an ETF gives you control the NAV mechanism does not. Our ETF vs mutual funds guide works through the full comparison.
What the honest comparison looks like
Two NIFTY 50 index funds hold the same 50 stocks in nearly the same weights. They are not meaningfully different products. The differences that remain, in order of how much they matter:
- Expense ratio — predictable, compounding, and the only one you can know in advance.
- Tracking difference over 3–5 years — the realised result of everything else.
- Fund size — large enough to trade efficiently, not so large that rebalancing moves the market.
- Tracking error — useful as a consistency check, not as a quality ranking.
Past tracking difference is a far weaker predictor than the expense ratio, because it contains luck: a fund that happened to hold cash during a bad week looks good. The fee is contractual.
We publish every NIFTY 50 index fund’s NAV and its 1, 3 and 5-year returns, computed from AMFI’s own published data, on the NIFTY 50 index funds comparison page — which is where the tracking difference described above becomes a number you can read off rather than estimate.
What an index fund does not protect you from
Worth stating plainly, because “passive” is sometimes read as “safe”:
- Concentration. The NIFTY 50 is capitalisation-weighted on free float. Its top few names and top two or three sectors carry a large share of the index. Owning the index means owning that concentration.
- Valuation. An index fund buys at whatever the index costs today. There is no mechanism by which it declines to buy an expensive market.
- Drawdowns. The fund falls with the index, in full, every time. Tracking it faithfully on the way down is the product working correctly.
An index fund removes manager risk and fee drag. It does not remove market risk, and it was never meant to.
Related reading
- ETF vs mutual funds — the transaction-mechanism comparison in full.
- Expense ratio — how the fee is charged and where to find the current one.
- NAV and exit load — what the daily price actually represents.
- Securities Transaction Tax — the cost the fund’s own rebalancing pays.
- NIFTY 50 index funds compared — current NAVs and returns for every scheme tracking the index.