Your faith in the stock markets is based on where the Sensex and Nifty are going. So you commit your money to an index fund that promises to invest in stocks in the exact same pattern as their benchmark indices.

Such a fund helps you avoid the fund manager's risk, while charging less fees. So if your index fund is a reflection of its benchmark index's portfolio, it should offer you returns in line with the index, right?

Ideally yes, but you'll be surprised to see a handful of index funds that have either outperformed or underperformed the indicies by a wide margin. How is this possible?

Swinging returns

We crunched numbers to check how index funds have performed. We took only pure index funds and left out index-plus ones -- schemes that passively manage around 80 per cent of their portfolios and actively manage the rest.

For the sake of consistency, we took one-year rolling returns for all index funds (an average of one-year returns over the past year). Only those schemes with a two-year track record have been chosen.

Further, we took five different one-year periods to check performance trends. Since index funds benchmark their performances against Nifty Total Returns Index (dividends paid by Nifty stocks that are added back), we added 2 per cent to Nifty returns as the market's dividend yield is around 2 per cent.

The numbers were bewildering. Tata Index Fund-Nifty (TIFN) was at the top of the heap. For the year ending 30 June, while Nifty returned 49.58 per cent, TIFN returned 55.24 per cent. (See table: Nifty Index Funds).

Similarly, on 6 June 2006, TIFN returned 55.14 per cent while Nifty returned 49.34 per cent. At the bottom of the pack was LIC [Get Quote] MF Index Fund-Nifty Plan (LIFN).

The scheme has underperformed Nifty by a big gap. So, while Nifty returned 49.58 per cent for the period ending 30 June, LIFN returned merely 39.52 per cent, an underperformance of 20 per cent.

The reasons: tracking error

There is always a mismatch between the index and the scheme's returns which is attributed to tracking error. Simply put, it is the difference between the fund's returns and the index's returns. An acceptable tracking error in India is around 2 per cent.

Expenses, of which management fees are the largest constituent, are the biggest cause of tracking error. All index funds charge management fees. The good news here is that these have been reduced to around 0.5 per cent, half of the earlier 1 per cent. LIFN and LIC MF Index Fund-Sensex are exceptions here.

They charge 1.38 per cent management fees and 2.50 per cent as total expenses, respectively.

Even at the current levels, Indian index funds are far more expensive than those in matured markets. For example, in the US, index funds charge around 0.15 per cent to 0.3 per cent as total expenses.

A high cash allocation is also responsible for a high tracking error. The maximum permissible cash level for the fund is spelled out in its offer document and varies from one to the other.

Funds hold cash to help meet redemption pressure. For example, from an average corpus size of around Rs 73 lakh (Rs 7.3 million), LIFN's corpus jumped to Rs 32 crore (Rs 320 million) in August 2005, fell to Rs 3.26 crore (Rs 32.6 million) in December 2005 and Rs 3.36 crore (Rs 33.6 million) in June 2006. So, when a large part of the fund's corpus moves out within a month, the only option left for the manager is to hold cash.

Similarly, Reliance Index Fund-Nifty has held an average of 29 per cent cash in the past year, although its offer document says that it would hold zero to 5 per cent in cash. The scheme's tracking error is 8.63 per cent, while its offer document expects it to be around 2 per cent.

Active management?

Although Sebi rules strictly prohibit index funds from actively managing their portfolios, market sources say some index funds may cross the line every once a while.

If you see that your index fund has invested in scrips in a different proportion from the ones in its benchmark index, it is possible that the fund is being actively managed. Reliance Index Fund, as per the scheme's June 2006 portfolio, holds 7.20 per cent in ONGC [Get Quote] and 6.73 per cent in Reliance Industries [Get Quote], while the index weightage is 10.56 per cent and 9.87 per cent, respectively.

TIFN's returns too raise doubts, but the fund house doesn't disclose its index fund portfolios on a monthly basis like it does for the rest of its schemes. This seems strange, but Ved Prakash Chaturvedi, CEO, Tata Mutual Fund, says, "When index funds invest in all the stocks in exactly the same proportion as they lie in the benchmark index, what is the need to disclose the portfolios?" We asked him to explain the fund's outperformance, but didn't get a reply.

The Derivatives route

Although many index funds avoid the use of derivatives, some have occasionally taken this route to protect downslides. For instance, if the fund manager expects markets to drop, he can sell index futures to hedge his portfolio.

"When investors invest in mutual funds, they expect us to make money, irrespective of whether they are actively-managed funds or index funds. That's the underlying message even though index funds are passive by nature," says a fund manager of a public-sector mutual fund.

A few other fund managers also confirmed that index funds occasionally actively manage because of pressure to outperform their peers or to protect the downslide, although none were willing to go on record.

Alternative to index funds

Index funds are not mandated to outperform or underperform the benchmark index. So if you think that markets will go up, but want to take an exposure to Nifty, it is not possible to buy all 50 stocks with as low as Rs 5,000; that is why you buy an index fund. And unless your index fund shows a low tracking error, they don't make much sense.

Why ETFs are better

These are close cousins of index funds and aim to mimic the index they are benchmarked against. ETF scores over index funds on two counts. First, since an ETF is listed on the market, you can buy and sell its units throughout the day like a share and not just at the end of the day net asset value (NAV).

Unlike conventional market listed equity schemes that trade at a huge discount to their NAVs, an ETF's structure ensures that its market price tracks its NAV very closely. For instance, as on 14 July 2006, the closing price of Benchmark Nifty BeES, India's first ETF, was Rs 317 and its NAV was almost the same at Rs 317.8715.

An ETF's structure also ensures that long-term investors are not much impacted by short-term inflows and outflows. "This helps reduce the fund's tracking error," says Sanjiv Shah, executive director, Benchmark Mutual Fund.

An ETF also has lower expense ratio. For instance, BeES' offer document says it will cap its expense ratio at 0.80 per cent. Index funds have charged 1.16 per cent on an average over the past year. Simple calculations show that if you invested Rs 10,000 in BeES and an index fund, each for a 20-year period and the market rises by 12 per cent compounded annually, you will earn Rs 83,579 from your ETF and Rs 78,330 from index fund.

Invest through ETFs and avoid index funds that have high tracking errors or wild performance swings.