Amit Prasad, 42, walked into my office with an unusual question. ?Why do various experts recommend specific index funds? Aren?t all index funds supposed to give the same returns?? It?s a good question, I replied. But let us first understand what an index fund is before we go any further.

What is an index fund?
An index fund is an equity mutual fund that invests in the stocks that constitute a specific index. For example, an index fund tracking the BSE Sensex will invest in stocks that constitute the BSE Sensex. Further, the weightage or the percentage of each stock will be the same as that stipulated in the underlying index. Such funds are expected to give returns very similar to that of the underlying index. So Amit?s question is quite valid. He argues that if each index fund invests in the same stocks in the same percentage, then logically the returns from every index fund should be identical. I agreed with Amit that in theory that should be so, but the reality is quite different.

If one looks at the returns provided by index funds tracking the BSE Sensex over the past year, one will find that the difference between these returns is as high as 5 per cent per annum. The difference in performance comes from various factors such as differing expense ratios (the amount the mutual fund charges to manage the capital, or from sudden influx or redemption pressure in smaller funds, or because some funds hold large amounts of cash to meet redemptions, or from brokerage paid on buying and selling of stocks. Expense ratio is a component of tracking error and is a recurring expense. Hence, all other factors being equal, it is better to choose a fund that has a lower expense ratio than one that has a higher expense ratio. Whatever the reason, it is important to know that all index funds will not give you identical returns.

Tracking error
The deviation from the index is called tacking error. Tracking error can be positive or negative. For the mathematically inclined, tracking error is calculated as the standard deviation between the mutual fund returns and the benchmark index returns. A positive tracking error indicates that the mutual fund is outperforming the index while a negative tracking error indicates that it is underperforming the benchmark index. Ideally, an index fund should have a tracking error close to zero.

Since most investors in index funds invest with a long-term horizon, a fund that is underperforming the index can have serious consequences on wealth creation. This is because of the role compounding plays in the creation of long-term wealth. For example, if the underlying index returns 15 per cent per annum for 10 years, an initial investment of Rs 1 lakh will be worth about Rs 4 lakh at the end of 10 years. On the other hand, a fund that is constantly underperforming the index by 2 percentage points per annum will return only 13 per cent per annum. An investment in this fund would be worth only Rs 3.4 lakh at the end of the 10-year period. It is therefore imperative to choose an index fund that has a low tracking error.

Low-cost exchange traded funds
Amit nodded and said that he now understood why experts recommend specific index funds. But Amit wondered if an index ETF is a more efficient option. An ETF (Exchange Traded Fund) is in simple terms an index funds that has to be bought or sold on the stock exchange. The tracking error of ETFs is usually much lower than that of index funds, and so its returns are likely to more closely reflect the returns of the underlying Index. An ETF is also traded on the stock exchange on a real time basis and so it is possible for an investor to take advantage of the volatility during the trading day and buy at a lower price or sell at a higher. But when buying an ETF, one has to factor in the brokerage costs paid while buying and selling the ETF. These brokerage charges are absent in case of an index mutual Fund. So if you are a long term buy-and-hold investor, an ETF is likely to provide you with returns that more closely reflect the returns of the underlying index, just like an efficiently run index fund with a low tracking error.

Amit then asked whether if one chooses to invest in an index fund or an ETF, one must choose a fund with a low tracking error. Is that correct? Yes, I replied because not all index funds give identical returns although they may track the same benchmark index. It is usually for this reason that experts recommend specific index funds. But you can also check the tracking error and decide on a fund yourself.