Blog Details

Evaluating Index Funds Beyond Just Investing
Index Funds: Why Simply Investing Is Not Enough — Evaluation Matters
Author: Surendra Jauhari
There is popular narration is famous that Index funds are stress free investment and it is simple way to capture the market return, means “set it and forget it”, these passive strategies are indeed superior to major active strategies for the average investment, but the ‘passive’ label can be misleading.
Index funds track a benchmark, even index funds follow the same index still it is not likely to be that all index funds perform the same. So, before reaching out to any decision investments must evaluate the index funds carefully. 
The Myth: Index Funds are the same
Two different index funds follow the same index benchmark like nifty 50 but they might perform different and return may vary over time. These differences seem small at initial level but over a long period of time, i.e. may impact significantly in wealth creation.
Reasons behind the differences:
1.    Fund management efficiency
2.    Cost and expenses
3.    Tracking quality
4.    Market conditions and execution timings.
Evaluation: Key metrics of Index funds
1.    Tracking Error: Tracking errors is most important metrics which closely measure that how index funds follow its benchmark.  Lower tracking error indicates a good management efficiency; funds closely mirror the index with minimal deviation. Fund manager effectively managing cash holdings, costs and rebalancing, allowing consistent and benchmark aligned with the return. Lower tracking error means funds has close lock-step with the index and reducing the risk of significant performance, have lower risk and low error is also desirable because low tracking error is due to having low expense, less transaction costs and cash holdings level.

Over a period of time, even small difference can compound.
A good index fund is one that tracks the index consistently, not occasionally.

2.    Tracking Difference: The real performance gap where as tracking error measure volatility of deviation, tracking difference shows the actual return gap between the fund and the index. Let me take you through real scenario with below data

Tracking difference simply tells that – how much money did O actually lose compared to the benchmark.
Fund A 3.38 -3.5%= 0.12 (under performance)
Fund B 3.50-3.50%= 0 (Perfect match)
On paper, Fund B looks better, now look at the behaviour of the fund:
Fund A: If you see table fund A has deviated exactly 0.02% from the index and that is predictable, tracking error is near 0, you can trust on the fund A.
In comparison fund B in March deviated (+3.40% vs 3%) and May (-2.50% vs -2%), tracking error is very high. In a bad year, fund B could suddenly underperform by 2-3% because it is not disciplined. Tracking error happens due to cash drag, corporate actions and impact cost.
Month    Nifty 50 (Rb)
Fund A (Ra)
Diff A (Ra−Rb)
Fund B (Rb)
Diff B (Rb−Rb)
 

As per above table fund A has exactly difference of 0.02% every single month. Fund b has difference from 0.1 to 0.5 month on month.
Fund A is superior because its tracking error is zero, it proves that the fund’s internal “engine” is perfectly synchronized with the Nifty 50.
Three Sophisticated metrics to watch:
Tracking Error vs Tracking Difference: While the expense ratio is what you pay, the tracking difference is what you actually lose;
The SLB Magic: In a traditional model means buying stocks, hold them and charge a management fee. But in the SLB model, the fund believes, lying a stock in the vault gathering dust. Meanwhile, some market players (like hedge funds and arbitrageurs) are desperate to borrow those specific stocks to enable short trades or cover settlement obligation.
How the logic works and lowers your effective cost.
The math offsetting the expense ratio
Investor Return = Index Return-Expense ratio
Investor Return =Index Return – (Expense Ratio-SLB income)
Example: 
Fund A Expense Ratio=0.2%
SLB Income generated=0.08%
Actual Drag on your investment = 0.12%
if you put these values in the formula, actually you find that how investor returns gained from these SLB income and reduced expense ratio by 0.08% out of total expense ratio of 0.2%.
Is there a catch: (The Risk Factor)
UTI and HDFC consistently demonstrate the highest hidden value because of two factors:
Massive AUM which is more than 21k, in several past years they have effectively subsidized SLB income from expense ratio by 3 to 7 points. How they edge them out slightly in the tracing difference.
Some other newer or smaller AMC’s, have higher tracking error due to lower AUM and less experience in SLB. 
Finally let’s take example fund A with expense ratio of 0.06% might have 0.25% higher tracking error due to lower AUM and less experience in SLB in comparison some top AMCs might have 0.20% expense ratio and 0.15% tracking difference, making them cheaper in reality.
Concentration Elephant: As you think Nifty 50 is properly diversified but it is not true, financial services still command around 37% of the weightage. Which might create “financial overload” risk.
Valuation (P/E 22)
18 to 20 fairly priced range, we are not in bubble until it is more than 28, but we are not also in cheap territory (<16). SIP in long term does not matter, but for lumpsum, we should go ahead in stagger.
The Stealth Overlap Trap:
Stealth overlap trap is a silent performance killer that effects over 70% of retail investors.
Let’s take example, you have three strategies/funds in your portfolio like Large-cap blue-chip funds, flexi cap and Nifty 50 index and all three fund likely to have Reliance Industries, HDFC and ICICI Bank, as their top holdings and at last the result would be instead of 10% exposure to all three companies, you might unknowingly have 25-30% of your total portfolio. If those companies underperform, your entire portfolio ‘leaks’ returns simultaneously.
 

Why it is dangerous:
•    False diversification
•    Redundant Cost
•    The Average Return Trap

Active share: 25% (the closet index warning)
In reality most active fund, have active share of only 25%, and that is considered very low. It means 75% of your portfolio is exactly the mirror of the index fund.
Active funds charge a higher expense ratio (typically 0.7% -1.5%) compared to index funds typically (0.1% - 0.2%). So, your 75% of your portfolio doing just same as Index fund, while your paying higher fees on your 75% of portfolio.
Advance Metric: The information ratio instead of just looking at the Sharpe ratio look at information. It means how much excess return a fund manager has generated compare to the index.
How to Fix a "Leaking" Portfolio
If our audit reveals a Stealth Overlap, we typically recommend a "Core and Satellite" restructuring:
•    Step 1: The Core (Low Overlap): Pick one solid Passive Index fund or one high-conviction Flexi-cap fund as your foundation.
•    Step 2: The Satellites (Unique Alpha): Add funds that specifically avoid the Nifty 50 "Top 10" stocks—such as Mid-cap, Small-cap, or international funds.
•    Step 3: Style Diversification: Don't just diversify by "Market Cap" (Large/Mid/Small). Diversify by Investment Style. Pair a Value fund (which buys cheap stocks) with a Growth fund (which buys fast-moving stocks). They rarely overlap
How to Fix Your Portfolio Overlap
1.    Check for "Clutter": If you have 3 different Nifty 50 index funds (e.g., SBI, UTI, and HDFC), you are doing nothing but increasing your paperwork. Consolidate into the one with the lowest tracking error.
2.    The 70/30 Rule: Consider holding 70% in Nifty 50 (Stability) and 30% in Nifty Next 50 (Growth/Diversification). This reduces your Financials exposure and increases your exposure to sectors like Chemicals, FMCG, and Healthcare.

Articles Written By – Surendra Jauhari

________________________________________
⚠️ SEBI Disclosure & Disclaimer
When discussing financial markets, projections, and economic targets, it is important to include a formal disclaimer in the Indian context.  
•    Educational Purpose Only: The data provided within the previous table and analysis  is for purely educational and information purposes and should not under any circumstances be considered as professional financial advice or a recommendation for buying/selling any financial instrument.
•    SEBI Registered Investment Advisor: Wealth+ Advisers(www.wealthplys.com)
•    Securities market investment involves market risks. All the relevant documents should be read cautiously before investing.
•    Risk of Loss: The values of investment may fluctuate both positively and negatively. Past performance does not in any way indicate future results. The level of risks is also qualitative data interpreted on the basis of historical information.
•    Accuracy of Data: Though utmost care has been taken for the accuracy of the information provided (including the target of $5 trillion and GDP positions), the market scenario is dynamic. The user is advised to check the facts through authentic channels, such as SEBI, RBI, or Ministry of Finance, before taking any investment decision.