SEBI passive fund norms: how index funds and ETFs are governed, from tracking error to debt index limits

Passive investing has stopped being a niche. By March 2026, passive fund assets under management in India reached Rs 14.12 lakh crore, according to AMFI data — a scale that makes the rulebook behind every Nifty 50 index fund and Sensex ETF genuinely worth understanding. That rulebook is the SEBI Circular on Development of Passive Funds dated 23 May 2022 (ref SEBI/HO/IMD/DOF2/P/CIR/2022/69), which set the framework for how index funds and exchange-traded funds are built, priced, disclosed and policed.

For the ordinary investor the choice is deceptively simple: an index fund or an ETF that both track, say, the Nifty 50. They hold the same 50 stocks in the same weights, yet they behave differently in your hands — one is bought once a day at NAV, the other trades live on an exchange like a share. This Midday Investment Pulse compares the two vehicles for a passive investor whose goal is low-cost, benchmark-matching equity exposure, and explains the guardrails the 2022 circular puts around both.

Side-by-Side Comparison

An index fund and an ETF are both open-ended schemes that replicate a benchmark, but the plumbing differs. An index fund is a conventional mutual fund unit: you subscribe or redeem with the AMC at the day's net asset value, and you can automate purchases through a SIP. An ETF unit trades on the NSE or BSE throughout the session at a live market price, which means you need a demat and trading account and you deal with a broker, not the fund house, for retail lot sizes.

The table below sets out the practical differences under the 23 May 2022 framework.

The cost angle matters most over a multi-decade horizon. Both vehicles carry an expense ratio, and passive funds sit at the low end of SEBI's Total Expense Ratio slabs — a subject we broke down in detail in our note on how SEBI caps mutual fund TER. Even a difference of 0.20 percentage points a year compounds meaningfully: on a Rs 10 lakh corpus growing for 20 years, that gap alone can run into six figures. Model your own numbers with the Oquilia SIP calculator or the lumpsum calculator before committing.

How SEBI Measures Passive Performance — Tracking Error

A passive fund is only as good as its fidelity to the index it copies. SEBI's 2022 circular anchors this on tracking error. As defined in the framework, tracking error is the annualised standard deviation of the difference between the daily returns of the underlying index and the scheme NAV — in plain terms, how consistently the fund's day-to-day movement mirrors its benchmark. The lower the tracking error, the more faithfully the fund reproduces its benchmark index.

For equity index funds and ETFs, the circular caps tracking error at 2% on an annualised basis. If the tracking error breaches that 2% ceiling, the AMC must disclose it and the trustees are expected to examine the cause. In practice, ETFs typically report lower tracking error than index funds, because an index fund holds a cash buffer to meet daily redemptions while an ETF's in-kind creation and redemption mechanism keeps it more fully invested.

Where full replication is not feasible — most obviously in debt, where you cannot always buy every bond in an index — SEBI relies on tracking difference disclosure instead. Tracking difference measures the annualised gap between the fund's returns and the index's returns over a period, and AMCs must disclose it so investors can judge how closely the scheme is hugging its benchmark. A fund that consistently lags its index by more than its stated cost is a signal worth heeding when you compare two schemes tracking the identical benchmark.

Debt Index Funds and ETFs — The Concentration Guardrails

Equity indices are largely self-diversifying; a debt index is not, because a single large issuer can dominate a bond universe. The 23 May 2022 circular therefore imposes constituent and single-issuer concentration limits on the indices that debt ETFs and debt index funds are allowed to track, so that a debt fund marketed as "passive" does not quietly become a concentrated credit bet.

These rules mean a Nifty PSU Bond Plus SDL style index or a target-maturity debt index cannot lean disproportionately on one borrower. For an investor, the takeaway is that a debt index fund's risk is spread by design across a minimum of eight issuers, but it is not risk-free — credit and interest-rate risk remain, and the tax treatment (covered below) changed materially from 1 April 2023. This is a different animal from the newer structured products SEBI introduced; we explained one such category in our piece on the SEBI Specialized Investment Funds framework.

Market Making and iNAV — Keeping the ETF Price Honest

An ETF's greatest convenience — a live, tradable price — is also its greatest risk if that price drifts from the value of the underlying basket. The 2022 circular addresses this with a market making framework: AMCs must appoint market makers whose job is to quote two-way prices and keep the ETF's market price aligned with its indicative NAV. That indicative NAV, or iNAV, is a near-real-time estimate of the value of the ETF's underlying holdings, and the circular mandates its disclosure during market hours so investors can spot when an ETF is trading at a premium or discount to fair value.

This matters at the point of purchase. If you place a market order on a thinly traded ETF, you may transact several rupees away from iNAV; a limit order pegged near the disclosed iNAV protects you. An index fund investor never faces this, because every transaction settles at NAV by construction. Before you decide which risks you are comfortable with, it is worth reading how SEBI grades scheme risk in our guide to the SEBI Riskometer's six risk levels.

Tax Treatment

Taxation does not depend on whether you hold an index fund or an ETF — it depends on what the scheme invests in. This is where investors most often trip up.

For equity-oriented index funds and ETFs — a Nifty 50 or Sensex tracker holding at least 65% in domestic equity — the rules revised by Budget 2024, effective for transfers on or after 23 July 2024, apply. Short-term capital gains on units held for less than 12 months are taxed at 20% under Section 111A. Long-term capital gains, on units held 12 months or more, are taxed at 12.5% under Section 112A, with the first Rs 1.25 lakh of such gains in a financial year exempt. You can see the LTCG and STCG definitions in our glossary.

Debt index funds and debt ETFs are treated very differently. For units acquired on or after 1 April 2023, gains on specified mutual funds are taxed at your slab rate under Section 50AA of the Income Tax Act, with no long-term capital gains concession and no indexation, regardless of how long you hold. A debt ETF held for a decade is therefore taxed exactly like a fixed deposit's interest — at your marginal slab.

One planning point for smaller investors: under the new tax regime for FY 2025-26, the Section 87A rebate is now Rs 60,000, which can wipe out tax on modest total income — but capital gains taxed at the special rates under Sections 111A and 112A are computed separately and are not sheltered by that rebate. If your goal is a tax-deductible equity route, an ELSS sits in a different bucket to plain index funds; verify the specifics against the primary source at incometax.gov.in before filing.

Who Should Pick Which

The right vehicle follows your behaviour, not the headline expense ratio. Three profiles cover most investors.

The disciplined monthly saver should almost always choose an index fund. Native SIP automation, no demat account, no bid-ask spread and no risk of transacting away from NAV make it the lower-friction path for someone investing, say, Rs 10,000 a month for 15 years. The marginally higher tracking error, kept within SEBI's 2% ceiling, is a small price for that simplicity.

The tactical or lump-sum investor deploying a large one-time amount — for instance Rs 20 lakh after a bonus or property sale — may prefer an ETF for its intraday execution and typically lower tracking error, provided they are comfortable placing limit orders near iNAV and already hold a demat account. Size the deployment first with the lumpsum calculator.

The debt-seeking investor should treat passive debt vehicles as a portfolio-construction tool, not a tax play, because the Section 50AA slab-rate treatment since 1 April 2023 removed the old indexation advantage. A target-maturity debt index fund can still make sense for matching a goal date, and for retirement mapping it pairs naturally with instruments like the NPS or a gold ETF allocation, but the tax must be modelled at your slab rate up front.

FAQ

What tracking error limit does SEBI set for index funds and ETFs?

For equity index funds and ETFs, the SEBI Circular on Development of Passive Funds dated 23 May 2022 caps annualised tracking error at 2%. Tracking error is the annualised standard deviation of the difference between the daily returns of the underlying index and the scheme's NAV, so a lower figure means tighter tracking.

Are ETFs always cheaper and more accurate than index funds?

ETFs typically report lower tracking error than index funds because their in-kind mechanism keeps them more fully invested, and their expense ratios are often marginally lower. But an ETF can trade at a premium or discount to iNAV, and brokerage plus bid-ask spread can erode that edge for small or infrequent buyers. Over a 20-year horizon, model both in the Oquilia SIP calculator rather than assuming.

How are gains from a Nifty 50 index fund taxed?

As an equity-oriented scheme, gains follow the Budget 2024 rules effective 23 July 2024: 20% short-term (under 12 months) under Section 111A, and 12.5% long-term (12 months or more) under Section 112A, with the first Rs 1.25 lakh of long-term gains each year exempt.

Why do debt index funds have a minimum of eight issuers?

The 2022 circular imposes single-issuer, group and sector concentration limits, and a minimum of eight issuers, on the indices that debt ETFs and debt index funds may track. This prevents a passively marketed debt fund from becoming a concentrated bet on a single borrower, spreading credit risk across the index by design.

Do I need a demat account to invest in an index fund?

No. An index fund is a conventional mutual fund unit bought and sold with the AMC at NAV, so no demat or trading account is needed. An ETF, by contrast, trades on the exchange and does require a demat account.

What is iNAV and why does it matter for ETFs?

The indicative NAV, or iNAV, is a near-real-time estimate of the value of an ETF's underlying holdings, which SEBI's 2022 circular requires AMCs to disclose during market hours. It lets you see whether the live ETF price is running above or below fair value before you place an order.

Is the Rs 60,000 rebate under Section 87A available on ETF capital gains?

Under the new tax regime for FY 2025-26 the Section 87A rebate is Rs 60,000, but capital gains taxed at the special rates under Sections 111A and 112A are computed separately and are not covered by that rebate. Always confirm your position against incometax.gov.in.