Decoding Index Fund Rankings: What Sets Them Apart?

When it comes to investing in the stock market, index funds have become increasingly popular. These funds aim to match the performance of a specific market index, like the Nifty50, Sensex, or SmallCap 100.

Unlike Active Mutual Funds, where we understand that depending on the returns of the fund, we can get some sense on the ranking. But for Index funds, if all the funds are following the same index, then how are they ranked?

Spoiler Alert - Active Mutual Funds are also ranked based on number of factors apart from returns generated, some overlapping with Passive (Index) Mutual funds.

Do check -

1. Expense Ratios: While index funds track the same index, they can differ in their expense ratios—the fees charged for managing the fund. Lower expense ratios mean more of your money stays invested, potentially leading to higher returns over time. So, when comparing index funds, look for ones with lower expense ratios. For Example - If XY Mutual Fund is charging 1% expense ratio while XZ is charging 2%. Suppose now you are investing 10,000 monthly in a mutual fund for 10 years and taking 15% as our growth rate. Then XY mutual fund cost will be 1.7L while XZ will cost around 3.28L. Hence as returns compound over time, these expense ratio costs also compound.
   

2. Tracking Error: Despite their goal to mirror the index, index funds may not perfectly replicate its performance due to tracking error. This is the variance between the fund's returns and the index's returns. Lower tracking error indicates a more accurate replication of the index's performance, making the fund more desirable.
   

3. Reinvestment of Dividends: Some index funds automatically reinvest dividends back into the fund, while others distribute them to investors. Reinvesting dividends can enhance returns over time by compounding, so funds that offer this feature may be more attractive to long-term investors.
   

4. Tax Efficiency: Taxes can eat into your investment returns. Index funds with lower turnover ratios—indicating fewer transactions within the fund—tend to be more tax-efficient. This means you keep more of your gains, boosting your overall returns. You can find this in it’s prospectus fillings. For simplification, if a fund has a turnover ratio of 50%, that means half of it’s investments were sold in previous 12 months and might be reinvested.
   

5. Fund Size and Liquidity: Larger index funds often have lower expense ratios due to economies of scale. Additionally, funds with higher liquidity—meaning they have more assets under management and higher trading volumes—tend to have narrower bid-ask spreads, reducing transaction costs for investors.
   

6. Reputation and Track Record: Lastly, consider the reputation and track record of the fund provider. Established fund providers with a history of successfully managing index funds may instill more confidence in investors.
   

Check this link out - HDFC Index Fund Nifty 50 Plan Direct -Growth: NAV, Review, Holding & Performance (etmoney.com)

This is how variance in returns can be checked by investor, before investing.

Disc. - Not an Investment Advice.

So, while index funds may all follow the same index, these factors can distinguish them from one another. When choosing an index fund, look beyond the index it tracks and consider these key factors to make an informed investment decision. After all, the small differences can add up to significant impacts on your long-term investment returns.