What to look for when investing in index funds

*Period for calculation (April 1, 2021 to March 31, 2022)

**For calculation of Sharpe Ratio, 6 percent risk-free rate (Rf) is taken.

These differences occur due to the composition of the index. For example, the Nifty 500 represents the top 500 companies based on full market capitalisation from the universe of companies meeting the eligibility criteria followed by the index provider NSE Indices Limited. The Top 100 companies from this index constitute the NIFTY 100, the next 150 companies make up for the NIFTY Midcap 150, and the last 250 companies constitute the NIFTY Smallcap 250.

From the Nifty 100, 50 companies, selected on the basis of free-float market capitalisation and impact cost, constitute the Nifty 50. The balance 50 companies from the NIFTY 100 after excluding the NIFTY 50 companies, constitute the Nifty Next 50.

The NIFTY 50 Total Return Index is the most popular index for index funds as it is the choice of 15 funds followed by the NIFTY Next 50 Total Return Index and the S&P BSE Sensex Total Return Index. For indices tracking the same capitalisation range, for example the BSE Sensex TRI and the Nifty 50 TRI, there are differences across risk and return. Prima facie it can be attributed to the number of stocks as part of the index.

However, one also need to recognise the differences in the methodologies used by the index providers. Since, indices are used as benchmarks, and now they are increasingly used for creating products like index funds and passively managed ETFs, there is a strong case for regulating the index providers, and bringing standardisation in the methodologies used by the index creators.

A majority of these funds are capitalisation driven funds, where weight of a stock is a function of its capitalisation. Apart from these broad-based indices, index funds are available on strategy indices such as the NIFTY 100 Equal Weighted Total Return Index, the Nifty 200 Momentum 30 Total Return Index, the NIFTY 50 Equal Weight Total Return Index, and sectoral indices such as the NIFTY Bank Total Return Index.

Investors need to understand that index funds based on sectoral indices are not fully diversified, and are subject to sector-specific risks. Similarly, investors need to understand that strategy indices also have different risk-return profiles than the market cap weighted indices. For example, though, the NIFTY100 Equal Weight Index comprises of the constituents forming part of the NIFTY 100 Index, the weights of the stocks in the NIFTY 100 Equal Weight Index are different than the Nifty 100 Index. The constituents of the NIFTY 100 Equal Weight Index are assigned equal weight at each periodic rebalancing that happens quarterly. Under this methodology, at the time of rebalancing every constituent would get an equal representation regardless of the size of each company in the Index. These funds are bound to have larger tracking error as they are required to rebalance the weights of all the stocks periodically.