Not all index funds are the same! Beyond top 100 stocks tracking errors are huge!

Published: June 22, 2021 at 10:16 am

In this article, we discuss why it does not make sense to invest in an index fund that does not track the top 100 stocks or lesser weighted by market capitalization. In other words, not all index funds are the same!

We shall not discuss ETFs here as they come with their own problems of liquidity: large sustained deviations between price and NAV. See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns! Also, the problems of tracking a large basket of stocks apply to ETFs too.

Let us take the one-year return difference (fund return minus index return) of different index funds (direct plan funds). This number will typically be negative (not always!). The  Data presented here is sourced from the Index fund tracking error screener June 2021 and is as of June 11th 2021.

  • Among five Sensex index funds: the lowest return difference is -0.46%. The next highest is -0.9% and above. Please note the more negative the number higher the deviation from the index (including dividends).
  • Among 16 Nifty index funds: Only three funds managed to keep the return difference less than -0.5%; Eight funds between -0.5% to -1%; Four funds above -1% and one fund with +1% (it beat the index!).
  • Among six Nifty Next 50 funds: only one fund with less than -1% and two funds with well above -2% return difference.
  • Axis Nifty 100 Index Fund: -1.11%
  • DSP Nifty 50 Equal Weight Index Fund: -1.03%
  • The two Nifty 100 Equal-weight indices (From Sundaram and Principal; Soon to be one fund as Sundaram has acquired Principal) clock in well above -2.9% and -2.7%.
  • Motilal Oswal Nifty 500 Index Fund: -1.88%
  • Motilal Oswal Nifty Midcap 150 Index Fund: -3.1%
  • Motilal Oswal Nifty Smallcap 250 Index Fund: -4.2%

Observations:

  • As the number of stocks increases, the deviation from the index increases.
  • If the weights become equal instead of determined by market cap tracking becomes difficult.
  • A big difference between tracking 50 equal-weight stocks and tracking 100 equal-weight stocks.
  • The deviations do not scale with the expense ratio. The average deviation for Nifty funds is about -0.7%. Motilal Oswal Nifty Smallcap 250 Index Fund has three times the expense ratio of a typical nifty fund, but its deviation is much larger.

Why does this occur? One reason is the poor liquidity of our markets. A way to understand this is via the impact cost. This is a measure of how difficult it is to buy or sell large quantities of stocks. If you wish to buy/sell a large quantity of a stock that is not frequently traded then there would be a bigger mismatch between buy and sell price. This results in deviations from the index.


If we look at the impact cost of the top 100 stocks by market capitalization on the NSE (published monthly) the bottom stocks have high impact costs. This is possibly why it is harder to manage a Nifty 100 equal weight index. A fund manager tracking Nifty 500 or the mid cap or small cap indices would end up buying a few stocks which no other fund house has purchased.

As long as the top 10/15 stocks dominate the weights, the deviation is reasonable. Up to Nifty 100, it is close to -1%. Beyond that, it rapidly increases. The ground reality is, there is no easy to “buy the entire market” passively without suffering loss. Much as the arguments presented in this article – The arithmetic of index investing explained – are enticing, they remain at the time of writing impractical to implement. I am not trying to say passive investing does not work; Just pointing out that venturing beyond Sensex/Nifty comes with a price and beyond the top 100, too high a price.

So what should investors do?

The following recommendations are based on the data available at the time of writing. If things change, then I am happy to change my opinion, but not before.

If you believe in passive investing then all you need is just one or two index funds (stay away from ETFs for long-term investing). A single Sensex or Nifty index fund will get the job done. Those who wish to venture beyond this (with the appreciation of what they are getting into) can consider a Nifty Next 50 Index fund. See: Combine Nifty & Nifty Next 50 funds to create large, mid cap index portfolios.

Do share if you found this useful

We now publish both equity fund and debt fund (+ hybrid fund) screeners each month!
Use our Robo-advisory Excel Template for a start-to-finish financial plan! Now with a new demo video!  More than 415 investors and advisors use this!
Unlock the secrets of successful financial advisors and entrepreneurs with our new course!
My new book for kids: “Chinchu gets a superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, if we had to groom one ability in our children that is key not only to money management and investing but for any aspect of life, what would it be? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parent’s plan for it and teach him several key ideas of decision making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Did you know? We have more than 1000+ videos on YouTube to explore! Join our YouTube Community!

Join our courses in exclusive Facebook Groups!

  • 550+ members are now part of our new course: How to get people to pay for your skills! (watch 1st lecture for free). Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show how to achieve by showcasing your skills and building a community that trusts you and pays you!
  • Goal-based portfolio management! Join 2220+ members and get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free!  One-time payment of Rs. 3000 only. No recurring fees! Life-long access to videos (10+ hours content)  in an exclusive Facebook Group! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.

Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!), or you buy the new Tactical Buy/Sell timing tool!
We publish mutual fund screeners and momentum, low volatility stock screeners .every month.
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations based on money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association, IIST Alumni Association. For speaking engagements, write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps