Index funds and ETFs: low-cost passive investing explained

An active fund is trying to beat a benchmark. An index fund is trying to be one. Everything else follows from that sentence — the cost, the risk, and the question of which you should hold.

What the Indian evidence says

S&P’s SPIVA scorecards measure Indian active funds against their own benchmarks, and the large-cap result has been consistent and uncomfortable for years: across five- and ten-year horizons, somewhere around three-quarters to four-fifths of active large-cap funds fail to beat the index they are measured against. The proportion that lags tends to grow as the window lengthens.

That is not because Indian fund managers are bad. It is arithmetic plus fees. The large-cap universe is a hundred well-covered companies that every professional in the country studies. Finding a durable informational edge there is genuinely hard, and an active large-cap fund starts each year roughly 1 to 1.5 percentage points behind an index fund on cost alone.

The picture is less settled further down the market-cap scale, where coverage is thinner and the dispersion between companies is wider. A reasonable reading of the evidence: the case for indexing is strongest in large caps and weakens as you go smaller — not that active management never works.

Index fund or ETF?

Both track an index. The difference is how you transact.

An index fund is an ordinary open-ended scheme. You buy at NAV, you can run a SIP into it, and you need no demat account.

An ETF trades on the exchange like a share. You need a demat account and a broker, you pay brokerage, and — this is the part that catches people — you transact at whatever price the market is quoting, which is not necessarily the NAV. On a thinly traded ETF the gap between the bid and the ask, and between the price and the underlying value, can quietly cost more than the expense ratio you were trying to save.

For most people investing monthly, an index fund is the simpler instrument. An ETF earns its place when you are deploying large amounts at once and the specific ETF actually has volume.

The two numbers that measure how well it tracks

They sound like synonyms and are not:

• Tracking difference is how far the fund’s return has lagged the index over a period. It is mostly cost, plus cash drag from money waiting to be invested. This is the one that shows up in your returns.
• Tracking error is how consistently it follows the index day to day — the volatility of the difference. Low tracking error means tight replication.

A fund can have low tracking error and a persistent tracking difference: faithfully lagging by the same amount every day. When comparing two funds on the same index, the tracking difference is what you actually pay.

You will also find R² on every fund page here. For an index fund it should be essentially 1.00 against its own index. Meaningfully below that is a fund not doing the one job it has.

Cost, and the new rules

Index funds and ETFs are cheap by design, and from 1 April 2026 SEBI’s revised framework caps their base expense ratio at 0.90% — though real index funds on mainstream indices charge a small fraction of that, often under 0.20%.

Against an active large-cap fund’s expense ratio, the gap compounds exactly the way the Direct-versus-Regular gap does, and for the same reason. What a fund costs is covered in what a fund really costs.

Where indexing does not automatically win

• Concentration is inherited. A Nifty 50 index fund is heavily weighted to financials because the index is. Indexing removes manager risk; it does not remove sector risk, and you have chosen the index’s concentration rather than avoided a choice.
• An index fund falls the whole way. There is no manager to raise cash. That is the deal, and it is fine — but a passive portfolio does not protect a drawdown you were not prepared for.
• Not every index is worth tracking. Narrow, thematic and factor indices are active bets in passive packaging, with the concentration of a sector fund and none of the discretion.

A practical position

The common conclusion among people who look at this evidence honestly: index the large-cap core, where the odds against active management are steepest and best documented, and be selective and patient with active exposure elsewhere. Compare any index fund against its peers on the screener using expense ratio and tracking error, not last year’s return — on an index fund, last year’s return is the index’s, not the manager’s.

Key takeaway

Indexing wins by not losing: it removes manager risk and most of the fee, and the Indian large-cap evidence is emphatic. Index the core, compare index funds on tracking difference rather than headline expense ratio, and remember an index fund inherits the index’s concentration and falls the whole way. Narrow thematic and factor indices are active bets in passive packaging.