Index funds and ETFs are the simplest way to invest in the stock market as a whole. Instead of a fund manager picking stocks they think will do well, these funds simply buy all the stocks in an index — such as the Nifty 50 or the Sensex — in the same proportions. Your return is, by design, close to the market's return, minus a small cost.
This approach is called passive investing, and it has become popular in India over the past several years. Here is how it works, what to look for, and how to decide between an index fund and an ETF.
What is passive investing?
In an active fund, a fund manager and research team decide which stocks to buy and sell, aiming to beat a benchmark index. Some do, some don't, and it is hard to know in advance which will.
In a passive fund, there is no stock picking. The fund mirrors an index. If a company makes up 10% of the Nifty 50, it makes up roughly 10% of a Nifty 50 index fund. When the index changes its constituents, the fund follows.
Why people choose passive funds:
- Lower costs, because there is no research team making active calls
- Transparency — you always know what the fund holds
- No manager risk — the fund won't underperform because of a poor stock call
- Simplicity — you are buying "the market", not trying to beat it
The trade-off: a passive fund will never beat its index. It aims to match it.
Common indices in India
| Index | Exchange | What it covers |
|---|---|---|
| Nifty 50 | NSE | 50 large, actively traded companies across sectors |
| Sensex | BSE | 30 large, established companies |
| Nifty Next 50 | NSE | The next 50 large companies after the Nifty 50 |
| Nifty Midcap 150 | NSE | 150 mid-sized companies |
| Nifty Smallcap 250 | NSE | 250 smaller companies |
The Nifty 50 and Sensex overlap heavily because both hold India's largest companies. The Nifty Next 50 is more volatile: it holds companies that are large but not the very largest, and its sector mix can differ a lot from the Nifty 50. There are also passive funds on sectoral, factor-based (such as momentum or low volatility) and bond indices.
Expense ratio and tracking error
Two numbers matter most when comparing passive funds that follow the same index.
Expense ratio is the annual fee, deducted from the fund's NAV. For index funds and ETFs it is usually much lower than for active funds, and SEBI caps it. Even small differences add up over decades.
Tracking error measures how consistently the fund's daily returns follow the index. A related figure, tracking difference, is the gap between the fund's actual return and the index's return over a period. Both arise from expenses, cash held for redemptions, and the timing of buying and selling.
Worked example. Suppose over a year:
- The Nifty 50 Total Return Index rose 12.0%.
- Fund X delivered 11.8% (tracking difference 0.2%).
- Fund Y delivered 11.4% (tracking difference 0.6%).
On ₹10 lakh, that gap is ₹4,000 in a single year — and it compounds. When two funds track the same index, a lower and steadier tracking difference is usually the better sign. These figures are illustrative; check actual numbers in each fund's factsheet.
When two passive funds track the same index, the one that follows it more closely and cheaply is usually the better choice. That is almost the whole decision.
Index fund vs ETF: what's the difference?
Both follow an index. The difference is how you buy and sell them.
| Feature | Index fund | ETF |
|---|---|---|
| How you buy | From the fund house, like any mutual fund | On the stock exchange, like a share |
| Demat account needed | No | Yes |
| Price | End-of-day NAV | Live market price during trading hours |
| SIP | Easy, automatic | Possible through some brokers, but not universal |
| Extra costs | Expense ratio only | Expense ratio plus brokerage and bid-ask spread |
| Liquidity | Redeem with the fund house at NAV | Depends on trading volume on the exchange |
Liquidity matters for ETFs. Some ETFs trade in small volumes, and their market price can drift away from the underlying value (called the iNAV). You might end up buying slightly above or selling slightly below fair value. Popular large ETFs usually trade closer to their iNAV.
In practice:
- If you want to invest monthly through a SIP and don't have a demat account, an index fund is simpler.
- If you already trade through a demat account and want to buy or sell at a live price, a liquid ETF can work well and may have a slightly lower expense ratio.
If you'd like to set one up, see our guide on how to open a demat account.
How taxation works
Equity index funds and equity ETFs are taxed like other equity funds. For FY 2025-26: gains on units held up to 12 months are taxed at 20%; gains on units held more than 12 months are taxed at 12.5% on amounts above ₹1.25 lakh a year. Debt index funds and gold ETFs follow different rules. Check current rules before you invest, as tax law can change.
Mutual fund investments are subject to market risks; read all scheme-related documents carefully.
Where passive funds fit
- As a core holding in a long-term portfolio, with active funds used selectively around it
- For investors who don't want to evaluate fund managers
- For long-term SIPs where low costs compound over many years
Index funds are still equity funds. A Nifty 50 fund can fall 20% or more in a bad year, so the usual rules about time horizon and an emergency fund still apply. For more on how passive funds compare with other categories, read our article on types of equity mutual funds.
Frequently asked questions
Is a Nifty 50 index fund good for beginners?
Many beginners find it a straightforward starting point because it is diversified across large companies, low-cost and easy to understand. It still carries market risk and suits long horizons.
Which is better, an index fund or an ETF?
Neither is better for everyone. Index funds are easier for SIPs and don't need a demat account. ETFs trade on the exchange at live prices and need a demat account; check their trading volumes before buying.
What is a good tracking error?
Lower is better. Compare funds tracking the same index rather than looking for one absolute number, and check the figure over more than one period.
Can index funds give negative returns?
Yes. They follow the index both up and down, so if the market falls, the fund falls too.
Key takeaways
- Passive funds aim to match an index, not beat it, at lower cost.
- Compare passive funds on expense ratio and tracking difference.
- Index funds need no demat account and suit SIPs; ETFs trade on the exchange and need one.
- Check ETF liquidity before buying.
- Index funds are still equity investments and need a long horizon.
You can see how a monthly SIP in any fund might grow with our SIP calculator, and our team is happy to explain the options on our investments page.
