Two wrappers, one idea
Both hold the index. The difference is how you buy them.
| Index fund | ETF | |
|---|---|---|
| Bought from | The fund house, like any mutual fund | The exchange, like a share |
| Price you get | End-of-day NAV | The market price at the moment of trade |
| Needs a demat account | No | Yes |
| SIP | Straightforward | Possible but clumsier |
| Additional costs | Expense ratio | Expense ratio, plus brokerage and the bid-ask spread |
| Extra risk | None specific | Market price can diverge from NAV |
For most people making regular contributions, an index fund is the simpler instrument. An ETF suits someone already trading on an exchange and transacting in size, where the lower expense ratio can outweigh the trading costs.
Tracking difference is the figure to read
Two similar-sounding measures, and they answer different questions.
Tracking difference is the gap between the fund's return and the index's return over a period. It is the number that actually cost you something, and it captures everything — expense ratio, cash drag, rebalancing costs, dividend timing, imperfect replication.
Tracking error is the volatility of that gap. It tells you how consistent the tracking is, not how much it cost.
Both are useful and they are commonly confused, including in fund marketing. For deciding between two index funds on the same index, tracking difference is the one that matters.
Which produces the point of this article: the cheapest fund is not automatically the closest tracker. A fund with a marginally higher expense ratio and better execution can deliver a smaller gap to the index than a cheaper one that rebalances poorly or carries more cash. Comparing expense ratios alone is comparing one component of the answer.
Compare tracking difference over several periods rather than one, since a single window can flatter a fund for reasons that will not repeat.
Where the gap comes from
- Expense ratio — the largest and most predictable component.
- Cash drag. A fund holding cash for redemptions is not fully invested, which costs return in a rising market and helps slightly in a falling one.
- Rebalancing costs. When the index changes constituents, the fund must trade — paying brokerage and impact cost, sometimes alongside every other fund tracking the same index at the same time.
- Dividend handling. The index may assume immediate reinvestment; the fund receives and reinvests with a delay.
- Replication method. Full replication holds every constituent; sampling holds a representative subset, which is cheaper and tracks less precisely.
All of it is measurable after the fact, which is why the published figure is a better guide than reasoning about the components.
The ETF-specific risk
An ETF's market price is set by supply and demand on the exchange, and its NAV is set by what it holds. Arbitrage normally keeps them close — but “normally” is doing work in that sentence.
On a thinly traded ETF, or during a volatile session, the price can move meaningfully away from NAV. You can buy above the value of the underlying holdings, or be forced to sell below it, and the difference is a real cost that appears nowhere in the expense ratio.
Three practical defences:
- Check average traded volume before choosing an ETF. Low volume means a wide bid-ask spread and greater divergence.
- Compare the market price against the indicative NAV published during the day, and do not transact when the gap is unusually wide.
- Use limit orders, never market orders, and avoid the opening and closing minutes when spreads are widest.
None of this applies to an index fund, which always transacts at NAV. That is the main reason an index fund is the simpler choice for regular investing.
Which index
The wrapper matters less than what is inside it, and this decision gets far less attention than it deserves.
A broad market index and a narrow one are different investments with the same structure. Sectoral and thematic index products are concentrated bets, and holding one passively does not make the concentration passive — it makes it undiagnosed.
Two questions worth answering before the fund choice: what does this index actually contain, in terms of concentration and sector weights, and how is it constructed? Market-cap weighting means the largest companies dominate, and in a concentrated market the top handful can drive most of the outcome — which is a real characteristic rather than a flaw, and worth knowing you own.
The honest case, and its limits
The argument for index investing is structural rather than a claim about markets. Cost is knowable in advance and return is not, so removing cost is the one reliable improvement available — the point made in the expense ratio.
An index fund also cannot underperform its index by more than its tracking difference, which bounds one kind of disappointment.
Two honest limits. It cannot outperform either — you are buying the market's outcome, including the bad periods, in full. And it will not protect you in a fall, because it holds what the index holds all the way down. Anyone choosing passive because it sounds safer has chosen it for the wrong reason; the reason is cost.
Whether active management earns its fee is a question per scheme, answerable by comparing it against its own benchmark over long periods rather than against its category.
Comparing on the number that matters
Fund houses publish tracking difference and tracking error for index products, and it is a short document.
Because the differences between funds on the same index are small, the comparison needs real history rather than a single figure. FNOTrader's Mutual Funds app runs against the full AMFI NAV history — around 34 million NAV rows — with rolling returns and benchmark-relative performance, so how closely a fund actually delivered the index across many periods is observable rather than asserted.
Common questions
What is the difference between an index fund and an ETF?
Both hold the index; the difference is how you buy them. An index fund is bought from the fund house at end-of-day NAV and needs no demat account; an ETF trades on the exchange at market price and adds brokerage, spread and the risk that price diverges from NAV.
What is tracking difference?
The gap between a fund's return and its index's return over a period. It captures everything that cost you — expense ratio, cash drag, rebalancing costs, dividend timing and imperfect replication — which makes it the number to compare.
How is tracking error different from tracking difference?
Tracking error measures the volatility of the gap, telling you how consistent the tracking is. Tracking difference measures the size of the gap, telling you what it cost. For choosing between two funds on the same index, the difference is what matters.
Is the cheapest index fund always the best?
No. A fund with a marginally higher expense ratio and better execution can deliver a smaller gap to the index than a cheaper one that rebalances poorly or holds more cash. Comparing expense ratios alone compares one component of the answer.
What is the risk specific to ETFs?
The market price can move away from NAV, especially in thinly traded ETFs or volatile sessions — so you can buy above the value of the holdings or sell below it. Check traded volume, compare against indicative NAV, and use limit orders rather than market orders.
Does an index fund protect me in a market fall?
No. It holds what the index holds, all the way down. The case for index investing is cost, which is knowable in advance while return is not — choosing it because it sounds safer is choosing it for the wrong reason.
Are sectoral index funds passive?
The wrapper is passive; the bet is not. A sectoral or thematic index product is a concentrated position, and holding it passively does not remove the concentration — it makes it undiagnosed.
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