Decoded: How you should choose the best index fund for wealth creation

Fueled by the surge of low-cost exchange-traded funds (ETFs) and index funds tracking key benchmarks like the Nifty 50 and Sensex, passive investing is gaining immense popularity in India.  In the past five years, assets under management (AUM) in passive products have skyrocketed, rising almost six times over the trailing period. The number of passive funds available to investors has grown from 149 in 2020 to 537 by December 2024, shows data analysed by Morningstar. 

 

As this investment trend continues to grow, selecting the right index fund has become an essential skill for investors aiming to tap into passive investing’s full potential. 

 

While passive funds can be an efficient way to invest, subtle differences in cost, tracking efficiency, and index methodology can dramatically affect the returns on these investments.

 

Here’s a simple checklist by  Kongkon Gogoi, Senior Analyst, Manager Research, Morningstar Investment Research India to help you select an index fund that meets your needs:

 

1. Focus on the Asset Class First

The first step in choosing an index fund is to decide on the asset class or sub-asset class that best aligns with your investment goals. Are you interested in broad exposure to large-cap or mid-cap equities, government bonds, or a specific theme like sustainability or technology? Alternatively, you might be looking for specialized exposures such as factor investing (e.g., low volatility, growth, momentum, or value stocks). Understanding your broader investment objectives is key before diving into specific index options.

 

2. Consider Investability

Investability refers to how easily the securities within an index can be traded. Indexes that track illiquid securities can lead to higher transaction costs and performance drag. For example, while AAA-rated bonds issued by central public sector enterprises (CPSEs) and state development loans (SDLs) are relatively liquid, they are not as frequently traded as government bonds, which could create liquidity issues in certain market conditions.

 

When evaluating an index, check whether there are investable products (ETFs or mutual funds) tracking the index. The presence of such products indicates that the index is practical for portfolio implementation and has sufficient liquidity.

 

3. Diversification and Representativeness

A key benefit of passive investing is diversification, which minimizes risks associated with individual securities. When selecting an index fund, ensure that the index you are investing in adequately represents the asset class or market segment. A highly concentrated index may introduce risks that undermine the benefits of diversification. While specialized or narrow indexes may seem appealing, they are typically better suited for tactical allocations rather than long-term, passive investing.

 

4. Evaluate Index Construction Methodology

The construction methodology of an index should be sound and based on an economic rationale. Indices like the Nasdaq-100 or the Dow Jones Industrial Average, for instance, may have peculiar selection criteria that don't necessarily align with sound investment logic. An index that uses arbitrary rules or subjective decisions (such as the S&P 500, which relies on an investment committee) may not provide the transparency needed for long-term investing.

 

Make sure the methodology of the index you are considering is transparent and based on objective criteria. This allows you to better predict the index’s performance across market environments.

 

5. Low Turnover

Turnover refers to the frequency with which the securities in an index are bought and sold. High turnover can lead to increased trading costs, especially in illiquid markets, which can diminish returns. A well-constructed index will seek to minimize unnecessary turnover. Look for funds that implement buffers for market-cap changes to limit turnover and reduce associated costs.

 

6. Minimize Tracking Error

Even the best-constructed index is only as good as its ability to track its underlying benchmark. Tracking error measures how closely an index fund’s performance matches that of its index. A low tracking error indicates that the fund is replicating the index accurately and efficiently. Investors should prioritize funds with a stable and low tracking error to ensure their returns closely align with the performance of the underlying index.

 

7. Role of Market Makers

When it comes to ETFs, the role of market makers cannot be overlooked. Market makers ensure liquidity and fair pricing by continuously providing buy and sell quotes. ETFs with strong and multiple market makers tend to have narrower bid-ask spreads and more efficient pricing. In contrast, funds with fewer market makers may suffer from poor liquidity, especially during market volatility.

 

In India, the Securities and Exchange Board of India (Sebi) has mandated that each ETF should have at least two market makers to enhance liquidity and pricing efficiency. Before investing, ask your ETF provider who the market makers are and how many are involved in facilitating smooth trading.

 

The difference between a well-constructed, efficient fund and one that fails to deliver often comes down to the details: Is the index well-structured, investable, and sufficiently diversified? These elements directly impact performance and risk, separating funds that merely exist from those that truly deliver. And don't overlook the unsung heroes—market makers—who keep ETFs liquid and prices fair.

 

A good index fund is more than just low fees. Focus on your due diligence and dig deeper before deciding. And when it comes to highly specialized thematic or narrowly focused indexes, be extra cautious—they may look compelling, but they don’t always deliver the diversification and stability that passive investors rely on.  Here are the key takeaways: 

Choosing the Right Asset Class Matters: Investors should first determine the appropriate asset class or sub-asset class before selecting a benchmark. Passive investing is most effective in efficient markets with broad coverage and high liquidity.

 

Assessing investability: Some indices include illiquid securities, making them difficult to track and costly to replicate Even in relatively high-quality fixed-income indexes like CRISIL IBX 70:30 CPSE Plus SDL April 2025 Index, nuances in market depth can present challenges.

 

Index construction and its pitfalls

•  Not all index methodologies are well-grounded in economic rationale.
• The Nasdaq-100 Index restricts inclusion to companies listed on the Nasdaq exchange, an arbitrary constraint that excludes several major firms and not much representative of the US equity market
• The Dow Jones Industrial Average (DJIA), despite its prominence, is flawed due to subjective stock selection and outdated price-weighted methodology rather than market capitalization weighting. This results in an index that does not accurately reflect market opportunities.

 

Diversification & representativeness

A well-structured index should mirror the underlying market composition.

Highly concentrated indices introduce idiosyncratic risks, reducing the diversification advantage of passive investing.

 

Market makers:  The overlooked backbone of ETF liquidity

 

•  Market makers are critical to ETF efficiency, ensuring fair pricing, tight bid-ask spreads, and smooth trade execution.

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 Weak market-making support can lead to liquidity issues, price dislocations, and higher trading costs, negating the benefits of passive investing.

 

 Investors tend overlook this factor, but market depth and competition among market makers directly impact an ETF’s tradability and cost-effectiveness.

 

    Key question to ask: Who is providing liquidity for this ETF, and how effectively are they maintaining pricing stability?

  

• Tracking error & fund efficiency

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• The ultimate goal of an index fund is to closely replicate its benchmark.

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• Investors should prioritize funds with low tracking errors to ensure minimal deviation from index returns.