What is the index fund in India and how do you assess the index fund tracking error?

Index fund in India is a passive mutual fund that aims to achieve capital appreciation by imitating or replicating an underlying index. The objective of an index fund or an index ETF is to passively replicate the index in terms of its portfolio composition.

A fund manager of an index fund has to keep track of any changes in the weightage or list of stocks. He/she does not have a say in the portfolio composition and has to imitate the performance of the index.

Index funds are suitable to those who do not require extensive tracking and anticipate performance that is in line with the market returns can look at an Index Fund.

The majority of the index funds returns equal to or slightly lesser than the benchmark index.

Index Funds tracking error is a measure of how much the fund performance has deviated from the benchmark index. Index mutual funds disclose their tracking error in the factsheet. The fund manager has to create a portfolio that mirrors the index performance as closely as possible. Tracking error occurs in both scenarios; i.e. outperforming the index and underperforming the index.

When selecting a mutual fund, you need to evaluate the index fund tracking error by looking at the following:

How much is the annualized index fund tracking error?
How much is the degree of variance in the index fund tracking error?
What is the index fund portfolio turnover ratio?
Investors prefer index fundsto avoid the fund manager’s involvement and the higher expense ratio in the case of an active mutual fund. However, investors of the Index Fund should keep in mind that portfolio concentration is high as compared to an actively managed mutual fund, which has a mandate to not exceed the cap of 10% allocation in a stock. As of May 24, 2021, the top three Sensex stocks had a total weightage of 31.57 percent. An actively managed fund, on the other hand, won’t have such a portfolio concentration risk.