Index fund: meaning, how it works and who it suits

How it works

If the Nifty 50 has 50 companies, the index fund buys those 50 in the same weights. When the index changes, the fund changes. There is no stock-picking decision, so there is little research cost, which is why index funds are cheap.

Why cost is the main selling point

SEBI's 2026 expense rules cap the base expense ratio of index funds and ETFs at 0.90%, well below the cap for active equity funds, and many index funds charge much less than that cap. Lower cost means more of the index return reaches you. See expense ratio.

Tracking error

An index fund should deliver the index return minus its costs. The gap between the fund's return and the index's return, beyond cost, is tracking error. Small, stable tracking error is good. Check the figure on the factsheet and compare funds that track the same index.

Index fund vs ETF vs active fund

Strengths and limits

• Strengths: low cost, broad exposure, no manager risk, simple to understand.
• Limits: it will fall exactly as much as the index. It also owns every stock in the index whether or not it is a good business. A popular index can be concentrated in a few large companies. And no index fund can beat its benchmark after costs.
• Not all index funds are alike: a Nifty 50 fund is very different from a small-cap or "factor" index fund. Check what the index is.

Who it suits

Investors who want a low-cost core for a long-term goal and do not want to pick fund managers. Many investors combine an index fund core with a smaller active allocation. Passive funds in India now hold ₹15.42 lakh crore, according to AMFI's August 2026 note, though that figure includes gold and silver ETFs as well as equity index products.