Index funds
Also written Index fund
A passive open ended scheme that replicates or tracks a specific index, investing at least 95 percent of total assets in that index's securities, bought and redeemed from the fund rather than on an exchange.
In plain language
An index fund does not try to beat the market. It tries to be the market.
It is a passive fund: instead of a fund manager choosing stocks and sectors, the scheme holds the same securities as the market index, in the same weightages. Its return is therefore expected to be in line with the index, and it uses no investment strategy to earn more.
The workbook draws the line between an index fund and its close cousin, the ETF, in one sentence: index funds are also passive funds but are not traded on stock exchanges. An ETF lists and trades on an exchange; an index fund is bought from and sold back to the fund, like any other open ended scheme.
How it works
SEBI's scheme categorisation places index funds and ETFs together under "Other Schemes", defined as an open ended scheme replicating or tracking a specific index, with a hard floor:
| Rule | Figure |
|---|---|
| Minimum investment in securities of the index being tracked | 95 percent of total assets |
| Maximum base expense ratio, including investment and advisory fees | 0.90 percent of daily net assets |
The low expense ceiling reflects the absence of active management. A fund of funds investing in liquid schemes, index funds and ETFs is held to the same 0.90 percent, measured including the weighted average expense ratio of the underlying schemes.
Index funds also appear in two special cases. Mutual funds may launch a passive ELSS under the "Other Schemes" category, based on an index of equity shares from the top 250 companies by market capitalisation. And index funds are among the schemes excluded from the standard NAV-upload deadline on the AMFI and mutual fund websites, alongside ETFs, fund of funds and schemes investing at least 80 percent overseas.
Passive funds, in the workbook's summary, offer transparency, lower costs and diversification compared with active funds.
A worked example
Illustrative numbers.
An index fund tracking a large cap index manages Rs 800 crore.
The 95 percent floor. At least 95% × Rs 800 crore = Rs 760 crore must sit in the securities of the index. That leaves no more than Rs 40 crore outside the index's securities.
The expense ceiling. The BER, including investment and advisory fees, cannot exceed 0.90 percent of daily net assets — on a steady Rs 800 crore that is at most about Rs 7.2 crore a year.
What the investor sees. Mrs Bhatia invests Rs 2,00,000 in the fund. Over a year the index returns 12 percent. If the fund charges 0.50 percent and tracks closely, she earns roughly 11.5 percent, or about Rs 23,000, against the index's Rs 24,000. The gap is not a failure of stock picking — there was no stock picking — it is mostly the cost of running the fund.
She redeems by sending a request to the fund at NAV. Had she bought an index ETF instead, she would have sold her units on the exchange at a price close to real-time NAV.
Why NISM asks about it
Chapter 4 (Characteristics of Other Securities) introduces index funds with ETFs in section 4.5 and Table 4.1. Chapter 10 (Mutual Fund Products) places them in SEBI's "Other Schemes" category, adds Box 10.1 on passive funds and passive ELSS, and asks in a sample question for the minimum investment in index securities — 95 percent, against 65, 75 and 80 percent distractors. Chapter 8 supplies the 0.90 percent BER limit, and Chapter 11 the NAV-disclosure exception.
Common exam traps
- 95 percent, not 65 or 80. The 65 percent figures belong to other categories; 80 percent is the overseas-investment threshold in the NAV rule.
- Index funds do not trade on exchanges; ETFs do. Both are passive, both track an index.
- The BER cap for index funds and ETFs is 0.90 percent of daily net assets, including investment and advisory fees — well below the 2.10 percent first slab for an active equity scheme.
- "Passive" does not mean "no expenses". The fund still charges within the 0.90 percent limit, which is one reason its return trails the index.
- Passive ELSS goes under "Other Schemes", not "Equity Schemes", and must be based on an index of the top 250 companies by market capitalisation.
- The 20/25 rule is stated not to apply to ETFs. The workbook does not extend that exemption to index funds.
Check yourself
1.How does an index-based ETF differ from an index fund, and from a close-ended mutual fund?
- a)An ETF is actively managed while index funds are passive
- b)Both ETF and index fund are passive, but only the ETF is listed and traded on a stock exchange — and unlike a close-ended fund, whose price shows a significant premium or discount to NAV, the ETF trades very close to real-time NAV with daily portfolio disclosure and low-cost intra-day trading
- c)An index fund is traded on an exchange and an ETF is not
- d)All three have identical characteristics
Show the answer
Answer: (b) Both ETF and index fund are passive, but only the ETF is listed and traded on a stock exchange — and unlike a close-ended fund, whose price shows a significant premium or discount to NAV, the ETF trades very close to real-time NAV with daily portfolio disclosure and low-cost intra-day trading
ETFs are passive funds that generate returns in line with the index or benchmark. There are no investment strategies used to generate higher returns other than what the index does.
Which disposes of option A — an ETF is not actively managed.
Index Funds are also passive funds but are not traded on stock exchanges. They are expected to offer a return in line with the market because they invest in a portfolio that mimics a market index. The portfolio of index funds consists of the same securities as that of market index in the exact weightages allotted to each security.
Both passive; only the ETF is listed — which reverses option C. An ETF is a type of mutual funds that are listed and traded on a stock exchange.
Table 4.1 supplies the comparison with the close-ended fund. Its transaction price shows a significant premium / discount to NAV, while the ETF trades very close to real time NAV.
The reason lies in the row above. The close-ended fund's only liquidity provider is the stock market; the ETF has fund and stock market — both, so the price cannot drift far from value.
Two further rows favour the ETF. Portfolio disclosure is daily against monthly, and intra-day trading is possible at low costs against expensive (due to bid-ask spreads).
And on NAV frequency: real time for the ETF, daily for both mutual fund types.
One row groups the ETF with the open-ended fund instead — unit capital is flexible for both, but fixed for a close-ended fund.
Beyond indices: other variants are also possible, such as, debt-oriented ETFs, Gold ETFs and Silver ETFs. Exchange Traded Funds offer a low-cost investment avenue to its investors.
2.The Net Asset Value of a mutual fund is:
- a)The market value per unit after charges and liabilities
- b)The par value of units
- c)The face value of the fund
- d)The fixed price at launch
Show the answer
Answer: (a) The market value per unit after charges and liabilities
Net assets refer to the net value of the portfolio, after charging the expenses. When we divide the net assets of a fund by the number of outstanding units issued, we get the net asset value (NAV) per unit.
And the formula: NAV is calculated as: (Total Assets – Liabilities) / No of units outstanding.
Market value, per unit, after liabilities — precisely option A.
Options B and C name the face value, which is fixed and typically Rs 10 per unit for most mutual funds. NAV starts there and then moves: Example 6 shows it going from Rs. 10.00 to Rs. 10.12 as the portfolio rose from Rs. 47,50,000 to Rs. 48,06,000, and falling to Rs. 9.47 had the portfolio dropped to Rs. 45,00,000.
Option D describes a launch price, which NAV certainly is not — NAV can move up or down, depending upon whether the value of the portfolio has moved up or down.
What goes into it. Net assets of a fund refer to the market value of the portfolio, plus accrued incomes, less any current liabilities and accrued expenses, a mutual fund having no long-term liabilities since the assets are fully funded by the unit capital contributed by the investors.
How precisely it is stated: 2 decimal places for equity oriented mutual funds and up to 4 decimal places for index funds and all types of debt/ liquid/ money market funds.
And how often: mutual funds declare the NAV of all their schemes on every business day, uploaded on AMFI's website (www.amfiindia.com) and the fund's own — by 11 p.m. of the same day, or by 10 a.m. the following business day for fund of funds.
For an investor, NAV is the most important data point to evaluate the performance of their investments, and RTAs ensure timely communication of latest NAVs to the unitholders.
3.As per SEBI categorisation, the minimum investment by an Index Fund in securities of the index being replicated shall be _______ of total assets.
- a)95 percent
- b)65 percent
- c)80 percent
- d)75 percent
Show the answer
Answer: (a) 95 percent
Index Funds/ Exchange Traded Funds: An open ended scheme replicating/ tracking a specific index. This minimum investment in securities of a particular index (which is being replicated/ tracked) shall be 95 percent of total assets.
Ninety-five per cent — the highest floor in the whole categorisation, and for good reason.
An index fund promises to mirror an index. Some funds are managed passively, selecting the same stocks as in a given index, in the same proportion. They do not actively choose stocks and sectors. Anything much below 95 per cent would let the manager take active positions and defeat the promise.
Chapter 4 puts it the same way — an index fund's portfolio consists of the same securities as that of market index in the exact weightages allotted to each security.
The same 95 per cent appears twice more. Fund of Funds (Overseas/ Domestic)... The minimum investment in the underlying fund shall be 95 percent of total assets, and Silver ETFs invest minimum 95 percent of the net assets of the scheme in silver and silver related instruments.
Three "pass-through" products, all at 95 per cent.
Option C's 80 per cent belongs to Large Cap, Sectoral/Thematic, ELSS, Corporate Bond, Banking and PSU and the Gilt funds; option B's 65 per cent to most other equity categories.
Why passive funds are encouraged. Passive Funds provide various advantages such as transparency, lower costs, diversification etc. to its investors over active funds — and SEBI now permits a Passive ELSS under 'Other Schemes' category, based on one of the indices comprising of equity shares from top 250 companies in terms of market capitalization.
Where this is taught
Free preparation for NISM Series II-BRelated terms
- Base Expense RatioThe management-and-administration slice of a scheme's cost, capped by the SEBI slabs — the first and largest of the four components that add up to Total Expense Ratio.
- Open-ended fundA mutual fund scheme with no maturity date that keeps selling and redeeming units directly after its NFO, at NAV-linked prices, so its number of units and unit capital change every day.
- Equity Linked Saving SchemeAn equity mutual fund category that carries a section 80C deduction of up to Rs 1.5 lakh with a compulsory three-year lock-in — the shortest lock-in of any tax-saving instrument.
- Exchange Traded FundA mutual fund scheme whose units are listed and traded on a stock exchange like a share, so you transact at live prices through the day instead of at one end-of-day NAV.
- Fund of fundsAn AIF that invests in the units of other AIFs rather than directly in investee companies — buying diversification across managers and strategies, and paying two layers of fees for it.
- Tracking errorThe gap between the return of a passive fund and the return of the index it is trying to replicate — the measure of how faithfully an index fund or ETF does its one job.
- Informational EfficiencyHow fully and quickly security prices reflect available information. It is what "market efficiency" usually means, as against operational efficiency, which is about transaction costs.
- Buy and Hold strategyA passive strategy of buying securities, or setting an asset mix, and then holding without trading — in equities for the long run, in bonds to maturity, and in rebalancing as "do nothing".
- InvestabilityA criterion for judging a market index: how easily investors can actually build a passive position matching it, given the liquidity of its constituent securities and how much weight each one carries.
- ReplicabilityA criterion for judging a market index: it should be possible to passively replicate the benchmark by holding its actual constituent securities in their index weights, rather than merely tracking it on paper.
- IndexingBuilding a portfolio that mirrors an index constituent by constituent — the most common form of passive management, carried out either by full replication or by sampling.
- SamplingAn indexing technique that tracks an index without holding all of it: some constituents are replaced by similar stocks, so the portfolio matches the index's risk and return rather than its exact list.
- ETF cost structureETFs carry a lower ongoing management cost than an equivalent index fund, but add brokerage, demat charges and the buy-sell quote spread on every trade — costs an index fund does not have.
- ETF liquidity in IndiaBarring a handful of exceptions, ETF trading volumes on Indian exchanges are thin, with wide buy-sell spreads and quoted prices that can drift well away from the underlying NAV.
- Target Maturity FundA debt mutual fund designed to mature on a specific date, holding bonds that mature around the same time — minimising reinvestment risk and giving a more predictable return to a defined horizon.
- Life Cycle FundAn open-ended scheme with a target maturity date between 5 and 30 years, which follows a glide path across equity, debt and other assets — shifting away from equity as maturity approaches.
- Multi Cap FundAn open-ended equity scheme investing across large, mid and small caps, with at least 75% of total assets in equity and at least 25% each in large-cap, mid-cap and small-cap companies.
- International assetsShares listed outside India, bonds in other currencies or real estate abroad — investments that carry the asset's own risk plus the effect of exchange-rate movements against the rupee.
- Passive fundA scheme that invests according to a specified index, holding its shares in the index's own weights, so it mirrors the index instead of trying to beat the market — and costs little to run.
- Smart Beta FundAn extension of index funds and ETFs that changes how the index is weighted — equal weights or other parameters instead of market capitalisation — to improve returns, diversify more and reduce risk.
- Glide pathThe pre-set schedule by which a Life Cycle Fund shifts its mix of equity, debt and gold ETFs as the fund approaches its target maturity date — equity down, debt up, over the fund's life.
- MF LiteA lighter SEBI regulatory framework, introduced in December 2024, for mutual funds that hold only passively managed products — index funds, ETFs, fund of funds or other schemes SEBI specifies.
- Quant FundA mutual fund scheme whose security selection is driven by pre-built, data-based models run through machines rather than by a fund manager's discretionary judgement.
- New cadre of distributorsA limited class of mutual fund distributors SEBI allowed from 2012 — postal agents and retired government or bank officers among them — who may sell only five kinds of simple and performing schemes.
- Index ETFA mutual fund scheme that invests in securities in the same proportion as an index of securities and lists on an exchange; it is taxed exactly like a listed equity oriented fund.
- Index futures and options horizonsThe workbook comparison of how long an index derivative can be held against how long an index fund can be held: a few days to a maximum of 3 months, against a lifetime.