What Is an Index Fund and How Does It Track the Index

An index fund is a mutual fund that buys the same securities as a market index, such as the Nifty 50, in the same proportions. It does not try to beat the index. Its return follows the index, less the fund’s expenses and a small gap called tracking difference.

Key facts

How an index fund builds its portfolio

Every index has a published rulebook, called its methodology, which sets how stocks are chosen and weighted. The Nifty 50, for example, holds 50 stocks weighted by free-float market capitalisation. That means a company’s weight depends on the value of shares available for trading, not all shares issued.

A Nifty 50 index fund holds those 50 stocks in those weights. When the index provider adds or removes a stock at a review, the fund sells the outgoing stock and buys the incoming one. The fund manager does not pick stocks or time the market.

SEBI’s scheme categorisation circular of 26 February 2026 lists index funds and ETFs under “other schemes”. It requires them to keep at least 95% of total assets in the securities of the index they track. The rest is usually held in cash or liquid instruments to meet redemptions.

Tracking error and tracking difference

An index is a number on paper. A fund has to buy real shares, pay costs and keep some cash, so its return never exactly matches the index. SEBI’s circular on passive funds dated 23 May 2022 defines two measures of that gap.

Tracking difference

Tracking difference is the annualised difference between the index return and the fund’s NAV return. If the Nifty 50 total return index gains 12% in a year and the fund’s NAV gains 11.6%, the tracking difference is 0.4 percentage points. It is mostly the expense ratio, plus the drag from cash and trading costs. Lower is better.

Tracking error

Tracking error is the annualised standard deviation of the difference in daily returns between the index and the fund’s NAV. It measures how consistently the fund follows the index day to day. A fund can have a low tracking error but still lag the index steadily because of its costs.

What SEBI requires

• Tracking error for index funds and ETFs, other than debt ones, must not exceed 2% on one-year rolling data. If it does for reasons beyond the AMC’s control, the trustees must be told.
• Debt index funds must keep their average annualised tracking difference over one year within 1.25%.
• AMCs must publish tracking error daily, and tracking difference monthly for 1, 3, 5 and 10 years and since launch, on their own website and AMFI’s.

When comparing two funds on the same index, tracking difference over several years is the more useful figure, because it shows how much return you actually gave up.

Expense ratio and why it matters here

Two funds tracking the same index hold the same stocks, so costs are the main thing that separates their returns. Under the SEBI (Mutual Funds) Regulations, 2026, the expense ratio of index funds and ETFs is capped at 0.90% a year. Many charge well below that cap.

Each fund has a direct plan and a regular plan. SEBI’s investor FAQ explains that a direct plan has a lower expense ratio because no distributor commission is paid from it, and a separate NAV. Our guide to expense ratio in mutual funds explains how the charge is deducted from NAV.

Types of index funds

A sectoral or factor fund copies its index just as faithfully as a Nifty 50 fund, but the index itself is narrower, so returns can swing more. An index fund and an ETF can track the same index. The difference is that you buy an ETF on the stock exchange during market hours through a demat account, while an index fund is bought from the AMC at the day’s NAV. See what an ETF is for more.

How to buy and redeem an index fund

1. Complete KYC with your PAN, Aadhaar and bank details if you have not invested in mutual funds before.
2. Choose the index you want, then compare funds tracking it on expense ratio and tracking difference.
3. Invest through the AMC’s website or app, MF Central, or a registered distributor or platform. Pick the direct or regular plan.
4. Invest a lump sum or start a SIP. Units are allotted at the applicable NAV.
5. To exit, place a redemption request on the same channel. The AMC must pay you within 3 working days.

Check the scheme information document for any exit load before you invest. Our SIP calculator shows what a monthly amount could grow to at a rate you choose. To see how different funds compare, the index funds comparison page lists funds by category.

Tax treatment

A domestic equity index fund counts as an equity-oriented fund. Under the Income-tax Act, 1961, which applies to FY 2025-26 returns, AMFI summarises the rates as:

• Short-term (held 12 months or less): 20% under Section 111A for units sold on or after 23 July 2024.
• Long-term (held over 12 months): 12.5% under Section 112A on gains above ₹1,25,000 in the year, for units sold on or after 23 July 2024.

From 1 April 2026 the Income-tax Act, 2025 applies, where the corresponding provisions are sections 196 and 198. Debt index funds that invest more than 65% in debt and money market instruments are “specified mutual funds” under Section 50AA, so their gains are taxed at your slab rate regardless of holding period. International index funds follow other rules. Our page on mutual fund taxation covers each type, and a tax professional can help with larger or mixed portfolios.

Frequently asked questions

What is the meaning of an index fund?

It is a mutual fund that copies a market index by holding the same securities in the same weights, so its return follows that index.

Do index funds for the Nifty 50 all give the same return?

They hold the same 50 stocks, but returns differ slightly because of expense ratios, cash holdings and trading costs. Compare their tracking difference.

What is a good tracking error?

Lower is better. SEBI caps it at 2% for equity index funds, and funds publish the figure daily on their websites and AMFI’s.

Is an index fund safer than an active fund?

It removes the risk of a manager picking the wrong stocks, but not market risk. If the index falls, the fund falls with it.

Can I start a SIP in an index fund?

Yes. Index funds accept lump sum investments and SIPs in both direct and regular plans.

What is the difference between an index fund and an ETF?

Both track an index. An ETF trades on the exchange at live prices and needs a demat account; an index fund is bought and sold with the AMC at the day’s NAV.

Sources

• Circular on development of passive funds, 23 May 2022 — SEBI (checked 16 Sep 2026)
• Categorization and rationalization of mutual fund schemes, 26 February 2026 — SEBI (checked 16 Sep 2026)
• FAQs for mutual fund investors — SEBI (checked 16 Sep 2026)
• Understanding tracking error — SEBI Investor (checked 16 Sep 2026)
• Tax regime for mutual funds — AMFI (checked 16 Sep 2026)
• Section 50AA, specified mutual fund — Income Tax Department (checked 16 Sep 2026)
• Methodology document for equity indices — NSE Indices (checked 16 Sep 2026)