Index funds are often hailed as the easiest way to own the market. They seek to imitate the performance of a tracking index, like Nifty 50 or Sensex, by duplicating the underlying securities and their respective weightages. However, most investors forget that not all index funds deliver exact returns to their underlying market index.
Even if this difference is small, it can result in a significant difference in the overall returns in the long term. In this blog, we will explore methods for determining whether your index fund is actually giving you the true market return, and the factors that may prevent it from doing so.
The myth of perfect replication
At first glance, index investing seems perfectly simple. The index fund holds the stocks in the index, in the same proportion as the benchmark they are tracking. Theory suggests it should yield precisely the same results before fees and expenses are factored in, but in reality, the overall returns have a slight difference from the benchmark returns, as perfect replication is nearly impossible.
For example, if the Nifty 50 rises by 12% on average every year, but your index funds only deliver 11.6% average returns, the difference of 0.4% is referred to as tracking error. Over time, these gaps can compound and subtly eat into the overall returns.
Key factors that affect index fund performance
There are several operational and market factors that determine whether your index fund will deliver the exact market return or not. Some of these factors are:
- Expense ratio: Even small variations in management charges can significantly add up in the long run. Performance can vary drastically with an expense ratio difference, resulting in a loss of thousands of rupees in the long term.
- Cash drag: A small amount of cash may be retained by the fund to meet redemptions or other purposes, causing a mild underperformance in a bullish market.
- Rebalancing frequency: The index fund rebalances from time to time, but fund houses may opt for less frequent rebalancing due to cost or liquidity concerns.
- Dividend treatment: In addition, the timing of dividends and reinvestment of dividends can also affect differences.
- Securities lending or sampling errors: In order to cut costs, many funds pursue what is known as a ‘sampling’ approach, where they replicate only a portion of the index stocks, which can result in imperfect tracking.
Passive investing doesn’t mean identical returns.
Investors often assume passive funds are identical to the underlying index they track, but they’re not, as it is not possible to exactly track an underlying index. Even index funds tracking identical indices could yield different returns.
For example, the UTI Nifty 50 ETF and SBI Nifty 50 ETF both follow the same index, but they can yield different returns due to tracking error, liquidity ratio, and expense ratio.
Before investing, investors should carry out comparisons of funds beyond the benchmark to make informed investment decisions.
How to evaluate if you’re getting the true market return
To ensure that your index fund is delivering the same returns as the benchmark it is tracking, investors should evaluate the following:
- Verify tracking error data: Reported by AMC or available in disclosures mandated by SEBI.
- Compare to benchmark performance: The same period return value is used to calculate the difference percentage.
- Monitor consistency: The long-term trend of deviation gives valuable insights regarding return difference.
- Compare fund expenses and AUM: Larger, cost-efficient funds often show tighter tracking.
When it comes to compounding, differences may be negligible for the short term, but small over the long term can result in substantial differences.
Bottom line
Index investing is one of the easiest ways to build wealth, although the assumption that all index funds track their benchmark Index accurately is false. If index fund investments aim to achieve the true market returns as the underlying benchmark, one must apply the same scrutiny as in active management, focusing on the tracking errors, costs, and replication ability.