Index Funds & ETFs — Passive Investing
Index funds and exchange-traded funds (ETFs) are passive schemes that aim to track a market index rather than beat it. This lesson explains how the two are bought and sold, what tracking error measures and how their expenses are capped.
What passive means
An index fund or an ETF aims to track a market index, not to beat it. The fund manager does not pick stocks by discretion; the portfolio is built to mirror the index.
A passive fund therefore carries the full market risk of its index. If the index falls, the fund falls with it, because there is no manager deciding to step aside. A fund house may offer more than one index fund or ETF, provided each tracks a different index.
Index fund and ETF: two ways to hold an index
An index fund is bought and redeemed with the fund house at the day's NAV. No demat account is needed.
An ETF is listed on a stock exchange and trades at a market price during trading hours. Buying or selling it needs a demat account and involves brokerage. The market price can be above or below the ETF's NAV, and exchange trades fall outside the cut-off times that apply to transactions made with the fund house.
Tracking error and tracking difference
After costs, a passive fund's return usually trails its index slightly. Tracking difference is the annualised difference between the scheme's return and the index's return.
Tracking error is the annualised standard deviation of the daily difference between the scheme's return and its index's return, over a rolling year. It shows how closely the fund followed the index day after day: a lower figure means it followed more closely. Performance is compared with the Total Return Index, which counts dividends as well as price changes.
Factor funds
Factor or smart beta funds track indices built by fixed rules on factors such as value, momentum, quality or low volatility, instead of weighting companies by market capitalisation alone. They remain rules-based rather than discretionary, and their returns can lag the wider market for long periods.
What a passive fund costs
Under the SEBI (Mutual Funds) Regulations, 2026 the base expense ratio of an index fund or ETF is capped at 0.90%. Since 1 April 2026 the total expense ratio is the base expense ratio plus brokerage, transaction costs and statutory levies, so those items are charged in addition to the 0.90%.
An ETF investor also pays brokerage to a stock broker on each purchase or sale on the exchange.
Rules at a glance
Two routes to the same index (illustrative)
Imran, 31, a teacher in Lucknow, has no demat account. He places a purchase in an index fund with the fund house and is allotted units at the day's NAV.
Deepa, 35, an engineer in Coimbatore, buys units of an ETF on the same index through her broker at 11 am, at the market price at that moment, and pays brokerage. Both now hold the same index. If it falls, both investments fall with it.
Tracking difference and an ETF's premium or discount (assumed figures)
- Assume an index, measured as a Total Return Index, gains 10.00% over a year and an index fund tracking it gains 9.70%.
- Tracking difference = 9.70% − 10.00% = −0.30 percentage point. The fund trailed its index by 0.30 percentage point.
- Now take an ETF with an NAV of ₹200.00 that is trading at ₹200.80 on the exchange. Premium = (₹200.80 − ₹200.00) ÷ ₹200.00 = 0.40%.
- If it trades at ₹199.40 instead, discount = (₹200.00 − ₹199.40) ÷ ₹200.00 = 0.30%.
Result. The index fund trailed its index by 0.30 percentage point over the year. The ETF buyer pays 0.40% more than NAV in the first case and 0.30% less in the second, before brokerage.
Key points
- Index funds and ETFs aim to track an index, not to beat it, and carry the full market risk of that index.
- An index fund is bought and redeemed with the fund house at the day's NAV; no demat account is needed.
- An ETF is listed, trades at a market price during trading hours, and needs a demat account and brokerage.
- An ETF's market price can be above or below its NAV.
- Tracking error measures how closely a fund follows its index; lower means closer.
- The base expense ratio of index funds and ETFs is capped at 0.90%, with brokerage, transaction costs and statutory levies on top.
Common misunderstandings
- Passive does not mean low-risk: an index fund or ETF carries the full market risk of its index.
- An ETF's traded price is not its NAV: the market price can be above or below it.
- The 0.90% cap is not the whole cost: brokerage, transaction costs and statutory levies are charged on top.
Questions people ask
Does an index fund need a demat account?
No. It is bought and redeemed with the fund house at the day's NAV. An ETF needs one, because it is traded on a stock exchange.
What does tracking error measure?
How far the fund's returns deviate from its index's returns, worked out as the standard deviation of the difference between the two. A lower figure means the fund followed its index more closely.
How does a factor (smart beta) fund differ from an ordinary index fund?
It tracks an index built by fixed rules on factors such as value, momentum or quality, instead of one weighted by market capitalisation alone. It is still rules-based, and it can lag the wider market.
What this lesson relies on
- SEBI (Mutual Funds) Regulations, 2026 — Regulations 66 and 67 (expenses)
- SEBI Master Circular for Mutual Funds (20 March 2026) — Chapter 3 (categorisation); provisions on tracking error and tracking difference of passive schemes; benchmarking against the Total Return Index
This lesson was reviewed independently against these sources on 8 October 2026. Rules change: check the current regulation, scheme document or policy wording before relying on any figure. This is education, not advice.