All Index Funds Track the Same Index. So Why Do Returns Differ?

Added: 2026-06-01

[00:00:00]As individual investors, it is very natural for all of us to sort all funds and then buy the best returning fund on the trailing returns.

[00:00:08]>> [music] >> Now, when investors decide to go passive, they often assume that the hard part is over. But the next step, which is actually picking the fund, that turns out to have more to it than expected.

[00:00:21]There are dozens of funds tracking the same index and they are not all identical. So, today we're looking at what separates one index fund from another. Joining me is Devender Goswami.

[00:00:32]He's founder Blue Rock Wealth and Pranit Mattoo, senior analyst at Value Research. Welcome, gentlemen.

[00:00:38]>> Thank you for having me.

[00:00:40]>> Thank you, ma'am.

[00:00:41]>> Mr. Goswami, I'll come to you first. So, um when an investor decides to go passive, the first thing that they discover is that there isn't just one Nifty 50 fund, you know, there are many all tracking the same index. So, um why do so many funds tracking the same index exist first? And then, why does the choice between them actually matter?

[00:01:03]Why can't I pick up any and go ahead with it?

[00:01:06]>> Thank you, Ruchita. First thing comes to our mind is this thing that there are several lot of AMC's and definitely all the AMC's are having Nifty 50 and all the general uh Joe index funds are there.

[00:01:21]So, how to choose them? There are certain criteria's to choose passive funds also.

[00:01:27]>> Mhm.

[00:01:27]>> Although they are on auto mode or auto pilot mode, but there should be uh criteria of tracking error, tracking difference, expense ratio, uh cash lag, and the actually uh the AUM also. Yeah, this can be the general criteria for differentiation of various schemes of any index. Be it Nifty 50, Nifty Nifty next 150, 100, 750, small cap, anything, anything.

[00:01:59]Yeah.

[00:01:59]>> Okay, so basically funds tracking the same index, they're not identical in outcome and the return an investor can investor actually receives that can differ across funds due to the factors that you've mentioned.

[00:02:13]>> Yes, of course, because there there are close to 700 passive funds right now.

[00:02:17]Their name is identical because SEBI has given the names as you have to true to label fund there should be true to label fund, but their fund management because of these criteria I already mentioned, they differ. The returns differ because the outcome is returns and investor is concerned with the returns only. But if you are do a do-it-yourself investor, a DIY investor, direct investors, then you need to analyze these funds on these basis. So index fund are also not easy to choose and track.

[00:02:55]>> Right. And the index that is the benchmark and not the product. So two funds can track the same benchmark, but then deliver different investor experiences, right?

[00:03:05]>> Yeah.

[00:03:06]>> Pranitha, I'll bring you in the conversation at this point. You know, most investors, they go straight to the expense ratio while comparing passive funds.

[00:03:15]Is that the right number to look at? The right starting point?

[00:03:19]>> Right. So look, the expense ratio is what every investor notices first and that is honestly fair because that is the cost of replicating the underlying index. So it should be substantially lower than your active funds peers in the same category.

[00:03:35]But I believe that there are a lot a couple more things as well that as Mr. Devender just mentioned about tracking error and tracking difference because these two reflect the funds ability to replicate the index. So while the expense ratio talks about the cost of replicating the index, the ability is being reflected by the tracking error and tracking difference. So, I'll take up the tracking difference first. So, tracking difference is basically the gap between what the index did and what your fund did. So, for example, if on any given year, Nifty 50 returns 12% uh annually and your fund return 11.5%.

[00:04:13]So, that gap of uh 0.5% is the tracking difference.

[00:04:18]And this tracking difference is primarily accounted for by the expense ratio, but it is but there are other components to it as well. And these components include uh transaction costs as mentioned by sir about cash lag and the positions taken to honor the redemptions as well. So, you what you want from your fund is to get this number as closer to the index as possible.

[00:04:42]And the second parameter is the tracking error. So, while tracking difference measures the crude gap between what the fund returned and what the index returned, the tracking error measures the volatility and the consistency of that gap over over time.

[00:04:58]So, what you want is that not just your fund to have the lowest gap at any given point in time, but you want your fund to have the lowest gap consistently throughout.

[00:05:08]So, which is why both of these numbers should be as low as possible in the category that you're picking your fund.

[00:05:14]So, that at least you are getting returns as closer to the possible to the index as you can.

[00:05:20]>> Right. So, uh Mr. Goswami, you handle hundreds of clients. So, in your experience advising them, uh do investors actually look at metrics like tracking tracking difference before choosing a fund or does this tend to get overlooked in practice?

[00:05:35]>> Yeah, uh practically speaking that they are not aware about these tracking error and tracking difference as well because as Prateek may mentioned the uh differentiation between tracking uh difference tracking difference and tracking error. So, it is in simplified manner tracking error is you know price list of restaurant.

[00:06:01]And tracking difference is whatever bill you get after completion of your meal.

[00:06:07]The overall output is tracking difference and tracking error is just price of one item two items. Right. So, to correlate the things with the your question investor many investors are not aware about the tracking difference as such they talk only about expense ratio but the investor DIY investor doesn't at all see them.

[00:06:34]Although that is not very good criteria to think of TER or BER whatever you call it because if the tracking difference is 50 better and TER is 70 better 70 bips then overall you are going to lose the returns and vice versa also vice versa also. If the expense ratio is 50 better and tracking error is 70 better 70 bips then overall you are going to lose going to get negative returns as compared to index.

[00:07:13]>> Right. So, one has to look holistically at these metrics. Apparently investors they also tend to check AUM. Does the size of a fund affect how well it tracks the index and is there a point where the fund is simply too small to trust?

[00:07:27]>> Right. So, thinking about AUM of the fund is something that has recently picked up. If you take the period of if I think Mr. Goswami can also pitch in on this since he has been looking at financial market for the past 20 odd years. He has seen a massive boom in AUM of the entire universe. So, if you look at about 20 years ago when our magazine of mutual fund insights started, the entire category's AUM was about 1 lakh crore. And now a single fund, the largest fund is over that size. So, which is why size is something that has recently started to gain prominence over the period. But, I believe that size becomes prominent and important to look at in an active fund. In the passive fund, it is a little counterintuitive to look at because in passive funds, it is the exact opposite. What you want is bigger and generally it is the better to have a bigger index fund.

[00:08:20]Because you want your fund to have achieved the economies of scale, and your fund be able to spread the operating cost over the entire AUM of a wider base. So, they will have an expense ratio. And as the fund grows in size, the fund is able to achieve economies of scale and thus offer a significantly lower expense ratio.

[00:08:41]And that is what we want from the fund.

[00:08:43]A cheaper index fund is a significantly better index fund assuming all the other factors that remain in the same.

[00:08:50]And so, so take the large cap space for instance. That is currently the largest passive universe dominance in the large cap space. It has about 153 index fund and ETFs the last I checked, and 96 of these funds have often AUM of less than 500 crores.

[00:09:10]And only about five of these funds have an AUM of over 50,000 crores.

[00:09:16]And if you map the expense ratio, the total expense ratio of what these funds are charging, that these two buckets are charging, you will see that the less than 500 class is charging an average expense ratio of 0.28%.

[00:09:31]And the largest 50,000 crore plus AUM funds are charging about 0.4%.

[00:09:38]So, this means that there is a difference of basically the smaller AUM are charging seven times what the larger fund is charging. And that seven times of extra cost can in turn significantly compound against you in the longer run. So definitely in passive investing size can act as your friend. But this is a more of a blanket statement and I do not think that it is right for you to get obsessive about chasing the largest passive fund. Because even if size does not size significantly matters in a large cap space because larger the size expense ratio will fall and then the tracking error tracking difference will fall. But within the small cap space and especially the micro cap space the larger the size can prove to be a significant of an issue. Because the underlying stocks simply do not have enough volume and liquidity to handle the excess large flows.

[00:10:33]So I ran through the numbers for this sometime back when the largest passive fund in all of these spaces the large cap the mid cap small cap and the only passive fund in the micro cap space. And I realized and I found out that the largest fund in the smaller universe is having a significantly higher tracking difference.

[00:10:55]So the largest large cap fund I think it is tracking the Nifty 50 if I'm not wrong. That largest large cap fund has a tracking difference of minus 0.27%.

[00:11:05]So that is what you are missing out compared to the index. But the largest micro cap the only micro cap fund has a tracking difference of minus 1.2%.

[00:11:14]So that 1.2% is significantly higher that's about six times what or maybe I think four times four to six times what the index fund could have offered. So you are getting 1.2% less from the get go itself.

[00:11:28]So this is why size matters as you go down the market cap ladder and otherwise if you are staying in the large cap space the larger the side the better it is.

[00:11:38]>> Mr. Goswami, since we're talking about the fund house, beyond the numbers, does the fund house behind the passive fund matter? And what should investors ideally look for when evaluating an AMC's passive business?

[00:11:53]>> Uh see, this passive fund is basically rule-based investing.

[00:11:57]>> Mhm. So, there are predetermined >> rule quant basis funds. Passive funds are already having set processes. So, to set the processes, to set the rules, the fund house should have enough vintage, enough vintage, enough backtesting tables, charts available, formulas available. And definitely here the bigger fund houses have grown too much in their R&D section. As per my analysis, as per my R&D only. So, they have gone too far in these things in passive funds and they have set much more processes than other AMCs. But definitely the larger team, larger processes, larger filtered processes rather, can go too far in the operations and they have set mechanism to set up the actually rules, the algorithms, the formulas which track the invest indexes very minutely. Because in passive investments, the minute tracking is very much important. I think. So, they they they are edging up, I think.

[00:13:15]>> So, while evaluating, what what is it that the investor should look for in a fund house to see if they should be buying you know, if they should be investing in a fund offered by the AMC?

[00:13:26]>> Yeah, here comes the outcome. The outcome is again tracking difference.

[00:13:32]So, whatever the returns you are getting, so you can just check the uh that tracking difference and tracking error and expense ratio as a whole in the last 1 year, 3 year, 5 year, whatever 7 year, 10 year because in passive funds there are uh index fund for more than now more than 10 years also. You can find the choose the better one.

[00:13:56]But, I think you have to research in passive funds also.

[00:14:00]That is not so easy.

[00:14:01]>> Right. And when it comes to evaluating an AMC, it is the uh you're saying the larger the AMC operational track record will be better or index management experience, that also counts.

[00:14:15]>> Uh larger team size are required to first set up the processes efficiently and uh to uh go for the R&D back testing as well. That is required. Otherwise, the passive fund once start, it goes autopilot mode. That is why it we call it passive. But, in the initiation these things are required. And reputation also required of the AMCs because to attract bigger money, you need to have reputation and vintage uh with you.

[00:14:47]>> Now, uh the passive universe, it now includes broad market funds. There are factor funds, sectorial funds, thematic funds, all technically passive, but how does an investor make sense of this expanding menu and figure out what actually belongs in their portfolio?

[00:15:06]>> Uh again, uh the same word for these beta active beta funds.

[00:15:13]So, they are these are factor-based fund, rule-based fund, or there can be market cap-based fund, weight-weight-weightage-based fund, you can say.

[00:15:24]So, if you are going for active investment in passive funds, then you can go for the hybrid hybrid option. So, if you can manage the advisor based management in passive funds, so low cost comes to passive funds, and advisor is advising you time to time what to take, what to sell, how long it you can go with these, and align all your financial goals with passive funds and active funds as well. You make your core and satellite portfolio as well.

[00:15:59]There there there you should catch the beauty of both worlds. I I I believe in beauty of both world. You can take the On the same time, you should take active funds, active beta funds, and passive funds.

[00:16:13]And there should be a right mixture of these all funds with the proper asset allocation mix with the advice of your advisor, financial distributor. And if you want to take it take to do it yourself, you can do it yourself if you have the right capabilities and right skill set for that. Then you can be the winner.

[00:16:36]>> Okay. Now, coming to ETFs, ETFs and index funds, they often track the same index, but they behave quite differently for the investor. So, when should someone go with an ETF over an index fund, and what should really drive that call?

[00:16:56]>> So, ETF is again now we are talking active investment in passive funds.

[00:17:03]>> Mhm.

[00:17:04]>> Now, this is this is ETF is very actively When you are taking strate- strategic move, tactical allocation, or you are just tracking the market intraday markets.

[00:17:18]So, you tend to buy ETF. For ETF, you need to have one demat account. From there, you can trade. And as as the name suggests itself, ETF is exchange traded funds. And you can take the pinpointed call in the ETF. But again, here comes the catch.

[00:17:38]There should be no difference in bid and ask. You have to check the history of those ETFs uh where the bid and ask difference should be minimum. Otherwise, if you are going to sell it any point of given point of time with certain news or certain event-based selling. And again, if the buyer is not available for ETF, then AMC is not going to take it back.

[00:18:03]AMCs ETF is always sold to secondary investor.

[00:18:08]It It cannot be given back to the company itself. So, there is fundamentally different fundamentally difference between ETF and index fund.

[00:18:17]Mhm. Index fund, redemption can be made very simple. And AMC pay back the money all the current value money. But in ETF, you have to you need to find one buyer for your units. And it depends key utna unit koi kharidne wala hai ki nahi. The buyer want to purchase those units.

[00:18:37]Otherwise, the bid bid and ask gap creates.

[00:18:42]>> So, as an investor, if I'm looking at these two options, there's an ETF and there's an index fund, how should I go about deciding which one should I choose out of the two?

[00:18:54]>> See, if you you can if you can research the things, you can research the markets, events, all the macroeconomics, microeconomics. And if the larger money is involved, larger money involved, and you are going for the lump sum investments, then you can definitely choose ETFs because their pinpointed timeline can be cashed the timing in the market. You can get the timing in the market. But, if you are the total mindset and you want to do it very gradually, you go by SIPs because SIP in ETF are not allowed.

[00:19:36]And in that index funds, you can go by SIP also. A small chunk of money is involved, and you are not eager to trade the markets. You want want to go it very very slow, consistently, disciplined manner, then you can choose the index fund. But, if the larger money involved and you have the team to research, you yourself can research, you have the right advisors on the board, then definitely you can go for the off for the ETFs also.

[00:20:06]>> Uh Pranav, one last question. Uh if you had to give investors a simple checklist, you know, five things to check before picking any passive fund, what would that be?

[00:20:15]>> The first would be that you should know the index itself, the underlying index that it is that is being tracked. Is it the Nifty 50, Nifty Next 50, a mid-cap, or a factor, or a small-cap index? What is the fund tracking? Because that will be the predominant uh return generator.

[00:20:32]Everything else will be secondary.

[00:20:34]The second will be that you need to evaluate what the fund that you will be buying will be adding to your current portfolio.

[00:20:43]So, for instance, it is very normal for investors to buy a Nifty 500 fund even when they already have a Nifty 100 fund.

[00:20:52]And this becomes counterintuitive because even while you are adding 400 stocks to your portfolio, the portfolio overlap between a Nifty 100 index fund and a Nifty 500 index fund is about 70%.

[00:21:05]So, despite you adding a new you [clears throat] are 70% the same fund. Your portfolio consists of 70% of the same stocks. You're not going to get anything different out of the lot. And then comes uh expense ratio and what is it what is its ranking within the category? Because the expense ratio is a combination of the cost involved and the transaction that the fund will have to do. And that is the determinant determinant of the beta spread as we discussed briefly before of the underlying universe. So, which is why as you go down the market cap ladder, it is natural for you to find that the expense ratio rises as we go down the market cap. So, a larger cap a large cap index fund will be cheaper compared to a small cap index fund.

[00:21:50]So, you need to compare it within the same category and then find the cheapest fund.

[00:21:55]>> Mhm.

[00:21:55]>> And then look at the tracking error and tracking difference to try to match the try to evaluate if the fund is giving returns that are as close to the index as possible and as consistently as possible.

[00:22:07]And fifth, I would want that you want to see the AUM of the fund and the direction that it it is heading.

[00:22:14]If the AUM of the fund is growing over time, then it is a overarching a good thing that the market perceives the fund to be a good fund for investors. However, if your fund's AUM is consistently taking hits and consistently following, which indicate that as market opinions, it is not a positive opinion on the fund, which is why the fund will have to take up more cash position to honor the redemptions, which could potentially impact the tracking error and tracking difference in the future.

[00:22:45]>> Right. So, my takeaway as an investor is that picking an index fund it involves more factors than it than initially might appear.

[00:22:52]Um you need to understand the index, evaluate the fund, how it fits your portfolio. Then there comes expense ratio, tracking error, tracking difference. You need to understand these and evaluate and the AUM as well. And knowing what each of these means and how much weight to give them can make the selection process more straightforward.

[00:23:11]Thank you both of you for joining in and sharing your insights. Thank you.

[00:23:15]>> Thank you. Thank you.