How to Choose the Right Index Funds for Your Investment Portfolio (2024)

If you are looking to invest in equity funds, index funds can be an ideal option for you. Index funds try to replicate an underlying index such as NIFTY 50, NIFTY Next 50, etc. Unlike active funds where the fund manager tries to cherry-pick stocks to generate higher returns for the investors, index funds simply offer returns that are in line with the underlying index. Investors can be better off going with index funds over active funds as in most of the categories active funds have been unable to outperform their benchmark index consistently.

There are multiple index funds replicating the same index. For example, there are more than 18 index funds that track NIFTY 50. So, how to choose one fund from the long list of available options?

Should you select an index fund that has given the highest returns in its category? But all these funds are trying to replicate the same index so shouldn’t the returns generated by them be identical? Or should you deep dive to figure out how well they track the index? Let’s find out.

Let’s start with what happens if you select an index fund on the basis of returns.

Selecting Index Funds Based On Returns

The table below shows multiple NIFTY 50 Index Funds. Taurus Nifty 50 Index Fund gave the highest 5-Yr CAGR of 12.22%. However, the difference in returns of Taurus Nifty 50 Index Fund and other index funds tracking the same index is not significant. But this fund comes with the highest tracking error among its peers.

Tracking error is a metric that tells us about the deviation in a fund’s returns vis-a-vis its benchmark. So, a lower tracking error implies that the fund is able to replicate the performance of the index in a more effective manner. To know more, read What is Tracking Error in Index Funds.

Data as on Feb 13, 2023

Since Taurus Nifty 50 Index Fund has the highest tracking error, we could find high deviation in the returns of this fund vis-a-vis Nifty 50 -TRI index, in some periods. For example, in the table below we can look at the returns offered by the The returns of Taurus Nifty 50 Index Fund were significantly different from the index in 2013 and 2019.

This high deviation led to high tracking error for this fund. And as an investor this is clearly something you don’t expect from an index fund. The marginal upside in the fund’s returns does not justify the volatility of this fund vis-a-vis its peers.

But why does this happen? Why do some index funds have higher returns than the other despite having the same securities in the portfolio?

There can be multiple reasons for higher returns in some index funds falling under the same category. For example, these index funds can invest up to 5% of the portfolio in debt papers to handle the inflows and the outflows. These can be short-term deposits, treasury bills, and other debt instruments. If investments in these instruments do well, they can add to the fund’s returns.

Apart from this, the fund can maintain a cash balance. If the fund has an adequate balance, it can deploy that cash during market corrections, which can also add on to the fund’s returns. However, these factors may not be able to contribute higher returns consistently.

So, chasing high returns may not be the right approach when selecting an Index fund. Then how can you choose an index fund?

How To Select An Index Mutual Fund?

When selecting an index mutual fund, the first thing you can do is to shortlist funds on the basis of the lowest tracking error. Doing this will help you identify which funds are able to track the underlying index effectively and consistently. You can get information on the tracking error of a fund through the fund’s fact sheet available on the mutual fund website.

Once you have a list of index funds that have similar tracking errors, you can refine your list further using parameters such as lower expense ratio and higher assets under management (AUM).

To strengthen your decision-making process you may also refer to ratings given to a particular fund by ET Money here.

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