How to choose an index fund?

An index fund is an investment that tracks a market index. Passively managed funds replicating an index have been on investors' radar for some time now. They have become a lucrative option, especially in the large-cap space, as the actively managed funds struggle to deliver superior returns over benchmark.

Though one has an option to invest either in an index fund or an Exchange Traded Fund (ETF) for tracking an index, investing through an index fund is a more straightforward route. One needs to have a Demat and a trading account for investing in an ETF. It trades on the stock exchange like any other equity share.

On the other hand, one can invest in an index fund exactly the way one invests in other mutual funds. Monthly automated investments through an SIP are possible. And having a Demat or a trading account is not mandatory. One must check two critical things while choosing an index fund.

Expense ratio - The lower, the better: The fund manager doesn't have a great role in managing an index fund, and he replicates the composition of the index. And that is why passively managed funds usually have a lower expense ratio than actively managed funds. Since all index funds tracking the same index would have the same portfolio, their cost becomes an important differentiator. The cost has a direct bearing on the returns of the fund. An index fund with a lower expense ratio than another tracking the same index is likely to return more. So look for an index fund with the lowest expense ratio.

Tracking error - The lower, the better: Tracking error happens when the fund cannot match the index movements. Say, an open-end fund tracks Nifty, and it goes up by 90 basis points, while Nifty itself goes up by 1 per cent. The difference would result in a tracking error. In other words, it is a measure of how efficiently the fund can track or replicate the performance of the index. Since the objective of an index fund is to track the index itself, the lower the variance, the better it is.

Choosing an ETF demands two more checks in addition to the points mentioned above - liquidity and the difference between the Net Asset Value (NAV) and the traded price on the exchange. Since an ETF is traded on the stock exchange, the price at which it is available may be less (at a discount) or more (at a premium) than the Net Asset Value (NAV) of the fund. One must be conscious of the same. Buying ETF units directly from the fund house may not be possible unless you plan to invest a huge amount. The other point is the liquidity - how frequently is the ETF traded on the stock exchange. An ETF with a lower trading value can be a hindrance when selling your investment.