Why a SEBI-compliant index fund must track its benchmark with 95% of its money

A fund is not passive because its name says so. It is passive because the regulator wrote a number into the rulebook. Since 6 October 2017, SEBI's categorisation circular SEBI/HO/IMD/DF3/CIR/P/2017/114 has required an index fund or an exchange traded fund to invest a minimum 95% of total assets in the securities of the particular index it replicates or tracks. Everything a passive investor thinks they are buying — the low cost, the predictable behaviour, the absence of a manager's opinion — rests on that single floor.

The rule matters most at the moment of choosing between the two wrappers it governs equally. An index fund is an open-ended scheme bought and sold at the day's NAV. An ETF is the same regulatory animal, listed, and bought and sold on an exchange at whatever price the order book happens to offer. Under the 6 October 2017 circular these are not two different exposures; they are two delivery mechanisms for one category, and the things that should decide between them are structural rather than performance-related.

The 95% floor, and what the other 5% is for

The figure is written as a minimum, which means 95% is the worst permitted composition rather than the design target. A scheme replicating a 50-stock benchmark in full can and usually does sit well above that line on an ordinary day. The up-to-5% headroom is not slack for stock-picking. It exists because a fund has to hold some cash to meet redemptions, has to park dividends between receipt and reinvestment, and has to absorb the timing gap when the index provider adds or removes a constituent.

That headroom is also where a measurable part of your shortfall against the benchmark is born. Money sitting in cash does not earn the index's return. If the benchmark index rises and a slice of the portfolio was in liquid balances for part of the year, gross return falls behind before a single rupee of expense ratio is charged. This is the mechanical reason a passive fund almost never matches its index to the decimal, and it is baked into the category by the way the 95% rule is drafted.

It is equally important to be clear about what the floor does not do. It is a portfolio-composition test, not a performance promise. Nothing in the 6 October 2017 circular tells you what a scheme will charge, how tightly it will track, or how wide the gap between an ETF's screen price and its underlying value will run on a thin trading day.

The companion rules on what a scheme may charge sit outside this circular altogether: SEBI's tiered expense-ratio caps for equity mutual funds are a separate instrument, and the 95% floor should be read alongside them.

Side-by-Side Comparison

Both wrappers are bound by the same minimum 95% allocation set on 6 October 2017. Everything below is a difference in plumbing, not in what the scheme owns.

Two consequences follow from that table, both of them downstream of the same 95% floor. The first is that an ETF adds a second gap to the one every passive scheme already has. An index fund's return differs from the index because of costs and the residual cash; an ETF's return to you differs for those reasons and again because you bought or sold at a market price that need not equal NAV. The second is that an index fund converts a monthly rupee figure into fractional units without friction, which is why recurring contributions are easier to model there. You can put your own numbers through Oquilia's SIP calculator or the lumpsum calculator to see how the two contribution patterns diverge over a holding period.

Neither structure is superior as an investment. The 95% floor makes them one category, and the honest comparison inside it is on cost and realised tracking.

Tax Treatment

For a scheme that is equity-oriented, the capital-gains treatment is set by statute and does not vary with the wrapper. Units held for more than 12 months are long-term; gains are taxed under Section 112A at 12.5%, and the first Rs 1,25,000 of aggregated long-term equity gains in a financial year is exempt. Units held for 12 months or less are short-term, taxed under Section 111A at 20%. Both rates took effect from 23 July 2024 under Budget 2024.

Three mechanics deserve attention. First, the Rs 1,25,000 exemption is an annual aggregate across all your long-term equity gains, not a per-scheme allowance, so holding the exposure in two wrappers does not double it. Second, for an ETF the gain is computed on the price at which you actually transacted on the exchange, not on the NAV published for that day, which means a sale at a discount to NAV reduces your taxable gain and your money alike. Third, the equity-oriented test is what brings Sections 112A and 111A into play at all.

That third point is where index-tracking products stop being interchangeable for tax. A scheme tracking a domestic equity index will ordinarily satisfy the equity-oriented test comfortably, precisely because the 95% floor forces it to. A scheme tracking a bond index, a gold price, or an overseas index holds securities that do not count towards that test, so it falls outside Sections 112A and 111A entirely and is taxed under whatever regime applies to its own class. Check the scheme's own stated category before assuming the 12.5% figure applies; the word "index" in a name settles nothing about tax. The Income Tax Department's return-applicability guidance for AY 2026-27 sets out which form carries which head of income.

Set against an administered-rate option, the contrast is worth stating in numbers. PPF pays 7.1% for the July to September 2026 quarter, unchanged for the ninth straight quarter, and that return is tax-free rather than taxed at 12.5%. A passive equity scheme declares no rate at all; the PPF calculator shows what the fixed side compounds to.

Who Should Pick Which

What follows is category mechanics, not a recommendation, and it deliberately names no scheme or fund house. The 95% rule makes the exposure identical; the choice is therefore about how you transact, not about what you will earn.

The index fund suits an investor whose contributions are recurring and whose amounts are not round. Fractional allotment means a fixed monthly debit of, say, Rs 5,000 buys exactly Rs 5,000 of exposure, and no demat account is needed. Someone running a monthly contribution against a long horizon is usually choosing between execution conveniences, not between returns, and the XIRR calculator is the right tool for comparing irregular contribution histories on a like-for-like basis.

The ETF suits an investor who already holds a demat and trading account, deploys in lumps rather than monthly slices, and is comfortable placing a limit order rather than accepting whatever the market offers on the day. The same 95% floor applies either way. The discipline that makes an ETF work is the one that makes it fail when ignored: if you transact at a wide spread on a thin order book, you have paid a cost the expense ratio will never show you.

Two situations argue against both. If you need the money inside 12 months, the short-term rate of 20% under Section 111A applies and equity market risk sits on top of it. And if the appeal of a passive scheme is that it feels like a savings product, that is a misreading of what the 6 October 2017 circular promises: it guarantees the portfolio will be the index, including when the index falls.

For tax-saving schemes the governing floor and the lock-in are different again; that ground is covered in the 80% equity floor and three-year lock-in SEBI hard-codes into tax-savers.

Reading tracking error before you commit

Once the 95% floor has guaranteed what a scheme holds, the remaining question is how faithfully it delivers what it holds. SEBI's investor education material defines tracking error as the difference between the returns of a portfolio and its benchmark index, and sets out two ways of expressing it: the simple difference between portfolio return and index return, and the standard deviation of that difference over a series of periods. The same material gives a worked illustration in which a fund tracking a 50-stock index reports an annual return of 9.8% against the index's 10%, a gap of roughly 0.2%.

Note what that illustration implies. A 0.2% annual gap is not a scandal and not a defect; it is the visible sum of the expense ratio, the residual cash the 5% headroom permits, the cost of buying and selling when the index is reconstituted, and the timing of dividend reinvestment. The number to compare across schemes is the realised gap, published by the fund itself, over a period long enough to be meaningful.

For an ETF, read one figure further. Tracking error, as SEBI's investor education material defines it, measures the scheme's portfolio against the index. It does not measure the distance between the ETF's traded price and its NAV, which is the gap you personally pay on the way in and collect or forgo on the way out. A scheme can track its index tightly and still hand a buyer a poor entry price on a day when the order book is thin.

The practical sequence is short. Confirm the index the scheme replicates and the 95% allocation the 6 October 2017 circular requires. Read the published expense ratio, then the published tracking error. For an ETF, check traded volumes and the typical spread before sizing the order. None of that requires a view on the market, which is the point of the category.

FAQ

Does the 95% rule mean an index fund must hold every stock in the index?

No. The circular of 6 October 2017 sets a minimum of 95% of total assets in the securities of the index being replicated or tracked. It fixes how much must be in index securities, not how many constituents must be held. A scheme may replicate fully or sample, provided the 95% floor is met.

What can the remaining 5% be used for?

The residual of up to 5% covers operational needs rather than active positions: cash to meet redemptions, dividends awaiting reinvestment, and the frictions of rebalancing when the index changes constituents. Because that residual does not earn the index return, it is one of the structural contributors to the gap between fund and benchmark.

Is an ETF taxed differently from an index fund?

Not by virtue of being listed. If the scheme is equity-oriented, Section 112A applies at 12.5% above the Rs 1,25,000 annual exemption for units held more than 12 months, and Section 111A applies at 20% for units held 12 months or less, both effective 23 July 2024. The difference is that an ETF's gain is computed on the exchange price you transacted at, not on that day's NAV.

Do index funds tracking gold or bonds get the 12.5% rate?

No. Sections 112A and 111A apply to equity-oriented schemes. A scheme tracking a bond index, a gold price or an overseas index does not satisfy that test simply by being passive, and is taxed under the regime applicable to its own class. Read the scheme's stated category rather than its name.

Why does a passive fund still lag its index?

Because the 95% floor is a composition rule, not a performance guarantee. The expense ratio, the residual cash the rule permits, transaction costs at index reconstitution, and dividend timing all subtract. SEBI's investor education illustration shows a fund at 9.8% against an index at 10%, a gap of about 0.2%.

Where do I verify the rule and the rates myself?

The 95% requirement is in SEBI circular SEBI/HO/IMD/DF3/CIR/P/2017/114 dated 6 October 2017, published at sebi.gov.in. The capital-gains rates of 12.5% under Section 112A and 20% under Section 111A, both effective 23 July 2024, are Budget 2024 provisions, and the Income Tax Department's portal at incometax.gov.in carries the return-applicability guidance for AY 2026-27.