Many index funds, which are supposed to mirror the performance of the underlying index, are actively managing their funds. No wonder, a lot of them are showing tracking errors of over 1 per cent (considered a benchmark in India).

LIC [Get Quote] Mutual Fund's Index Sensex Scheme, which has an annual tracking error of 7.53 per cent, and HDFC [Get Quote] Index Nifty, which has a tracking error of 3.57 per cent, are examples.

Tracking error is the difference between returns of the index and the fund. For instance, if Sensex gives returns of 30 per cent annually and the index fund gives returns of either 25 per cent or 35 per cent, it implies a tracking error of 5 per cent.

"Internationally, even 0.5 per cent tracking error is on the higher side," said Rajan Mehta, executive director, Benchmark Asset Management.

His index fund, Nifty BeES, has a tracking error of 0.18 per cent.

Mutual fund experts say that fund expenses, cash management and derivatives trading are reasons why index funds have failed to imitate their benchmarks.

Though index funds' expenses have been capped at 1.5 per cent a year, the maximum permissible cash level for the fund is spelt out in its offer document and varies from one to the other.

Ideally, such funds should not hold any cash because they are supposed to allocate the assets under management in stocks comprising the index and in the same proportion. But in case of Indian funds, they put clauses in their offer document that allow them to do so.

For instance, LIC's index funds can hold up to 10 per cent cash, according to their offer document. "If a fund is holding high cash and the benchmark scrips go up, the fund will lose out on returns," said Nilesh Shah, Chief Investment Officer, ICICI [Get Quote] Prudential Asset Management Company.

Keeping up with Sensex and Nifty was another reason why the tracking error occurred, according to some experts.

"In a bull market, the weightage of stocks in the index keeps changing. Last year, stocks such as DLF replaced Dr Reddy's in the 30-share index of BSE. And fund managers, who reacted late to such changes, lost out on gains," said Devang Shah, a certified financial planner.

But the greatest malaise seems to be active-management. Some managers started playing the derivatives market when it started sliding in January to limit their losses. Many burnt their fingers in the process.

Nilesh Shah countered the active-management argument. "I am not an economist but a fund manager. When investors invest in mutual funds, they expect us to make money. Within my mandate, if I can generate more money, I will definitely pursue it," he said.

The result is obvious. While ICICI Prudential's Index fund gave 2.28 per cent more returns than the Nifty, ICICI Prudential SPIcE's returns were less by 2.01 per cent compared to the Sensex.

Devang Shah is of the view that index funds are supposed to be managed passively. If they use derivatives trading, it is not in the spirit of the theme.

"I will not advise clients to invest in such funds as they can be risky in case of error in the judgement of the fund manager," said Shah.