Index Funds and the New 95% Tracking-Accuracy Rule

12 August 2026

Index fund investors picked passive funds for one reason: predictability. You're not paying for a fund manager's judgment, you're paying to own the index, as closely as possible, at low cost. A new SEBI rule effective April 1, 2026 puts a hard floor under that promise, and it's worth understanding both what it actually requires and what it doesn't fix on its own.

Key Takeaways

Under the SEBI Mutual Fund Regulations 2026, effective April 1, 2026, index funds and ETFs must invest at least 95% of assets in the securities of the index they track, and fund-of-funds must invest at least 95% in their underlying fund(s).
This rule limits how much cash or off-index holdings a fund can carry, but it doesn't cap tracking error directly, that's a separate, older requirement (2% for equity index funds/ETFs).
The base expense ratio cap for index funds and ETFs dropped from 1.00% to 0.90% under the same 2026 overhaul, which structurally reduces one source of tracking difference.
The 95% rule alone doesn't tell you if a specific fund is a good pick. You still need to check tracking error, tracking difference, and expense ratio individually before investing.
Existing fund holdings aren't disrupted by this change; AMCs are expected to already be compliant or adjusting portfolios without requiring investor action.

What does the 95% rule actually require?

The rule is straightforward on paper: index funds and ETFs must hold at least 95% of their assets in the securities that make up their tracked index, and fund-of-funds built on other funds must hold at least 95% in those underlying funds. This came in as part of SEBI's broader Mutual Funds Regulations 2026, approved in December 2025 and effective from April 1, 2026, the first major rewrite of the mutual fund rulebook in nearly three decades.

The intent is narrow but important. Passive funds have always been allowed to hold a small cash buffer to manage investor redemptions without forced selling of index constituents. But without a floor on how much of the portfolio has to actually mirror the index, a fund can drift, holding more cash than necessary, sitting in instruments outside the benchmark, or simply not rebalancing promptly when the index itself changes. The 95% floor caps how far that drift can go. In passive investing, the fund is supposed to behave like the index, not like an active fund quietly running a cash position, and this rule enforces that discipline structurally rather than leaving it to individual fund manager discretion.

It's worth being precise about what this rule is and isn't. It sets a minimum allocation threshold. It does not, by itself, cap how much a fund's returns can deviate from the index, that's tracking error, and it's governed by a separate, older SEBI requirement.

How is this different from the tracking error limit that already existed?

Tracking error and the 95% rule solve related but distinct problems, and conflating them is the most common mistake index fund investors make when evaluating a passive fund. Tracking error measures how much a fund's day-to-day returns deviate statistically from the benchmark's returns, calculated as an annualised standard deviation over a rolling one-year period, and SEBI's older passive fund circular already caps this at 2% for equity ETFs and index funds. Tracking difference, a related but separate metric, measures the plain gap between the fund's actual return and the index's return over specific periods, disclosed monthly across 1, 3, 5, and 10-year windows.

The 95% rule works upstream of both. It restricts what the portfolio is allowed to hold, which in turn constrains how much tracking error and tracking difference can build up from portfolio composition alone. But a fund can technically hold 96% or 98% in index securities and still post a mediocre tracking error if the remaining allocation, or the fund's rebalancing discipline, isn't managed well. The 95% floor is a structural guardrail; it isn't a performance guarantee.

Practically, this means checking one number instead of the other, or assuming compliance with the 95% rule tells you a fund tracks well, will give you an incomplete picture. Both numbers are worth pulling before you invest, and they answer different questions.

Why did the expense ratio cap change matter alongside this rule?

The base expense ratio cap for index funds and ETFs was reduced from 1.00% to 0.90% under the same 2026 regulatory overhaul, and this connects directly to tracking accuracy because fees are one of the largest structural drivers of tracking difference. A passive fund's return will almost always trail its benchmark by roughly the amount of its expense ratio, since the index itself doesn't pay any fees and the fund does. Lowering the fee ceiling narrows the floor of how far behind the index a compliant fund's return can structurally fall, even before accounting for cash drag or rebalancing lag.

This gives you a useful diagnostic when comparing funds: if a fund's tracking difference is meaningfully larger than its expense ratio, something beyond fees is driving the gap, cash drag during a rising market, delayed rebalancing after an index reconstitution, or portfolio composition issues. That gap is worth investigating rather than ignoring, since it points to execution quality rather than just the cost structure.

A subtlety that gets lost in most coverage of this rule: lower fees and the 95% floor push in the same direction but solve different failure modes. Fees are a known, disclosed, unavoidable drag. Off-index cash and lagging rebalancing are avoidable execution failures. The 2026 reforms tightened both simultaneously, but only the second one (the 95% rule) is really about tracking discipline; the fee cut is about cost, and conflating the two when evaluating a specific fund can lead you to over-credit a fund for "compliance" that's actually just a cheaper expense ratio doing the work.

What should you actually check before investing in a specific index fund?

Compliance with the 95% rule is now baseline and mandatory, so it isn't a differentiator between funds, every compliant fund clears the same floor. What differentiates funds is how they perform within that floor, and that comes down to three numbers you should pull individually rather than assuming the new rule covers for you.

Tracking error, found in the fund's Scheme Information Document, Key Information Memorandum, or monthly factsheet on the AMC's website. This is disclosed on a rolling 12-month basis and tells you how consistently a fund's daily returns have moved in step with the index. Consistency across multiple years matters more than a single low reading; a fund that's stayed in a tight range year after year is doing its job reliably.

Tracking difference, the actual return gap versus the benchmark, disclosed across 1, 3, 5, and 10-year windows since the SEBI passive fund circular mandated this. This is the number that answers the question investors actually care about: how much of the index's return did I actually receive. Watch for a negative tracking difference too, a fund that's consistently beating its index isn't necessarily a bonus. It can indicate the fund is taking on risk outside its stated mandate through derivatives or timing bets, and consistent outperformance from a fund that's supposed to be purely passive is worth questioning rather than celebrating.

Expense ratio, now capped lower under the 2026 rules but still varying meaningfully between fund houses tracking the same index. A lower expense ratio directly narrows the structural tracking gap, so all else equal, the cheaper fund tracking the same index has a real edge, not just a cosmetic one.

Does this rule mean you need to review your existing index fund holdings?

No, not urgently. The 95% rule is a compliance requirement AMCs need to meet going forward, and fund houses are expected to already be compliant or actively adjusting portfolios to meet it without requiring any action from existing investors. This is one of several changes in the broader 2026 overhaul, alongside new portfolio overlap limits for thematic and sectoral funds and the phase-out of the Solution-Oriented category, where SEBI has built in transition timelines specifically so that existing investors aren't forced into disruptive portfolio changes.

That said, "no urgent action needed" isn't the same as "nothing to check." If you're adding fresh SIP instalments to an existing index fund, or comparing index funds for a new allocation, this is a reasonable moment to pull that fund's current tracking error and tracking difference figures from its factsheet and confirm they're still in a range you're comfortable with, since AMC websites are required to publish this data regularly regardless of the new rule.

Frequently asked questions

Does the 95% rule guarantee that an index fund will have low tracking error? Not by itself. The 95% rule sets a floor on how much of the portfolio must mirror the index, which constrains the room for drift, but tracking error also depends on rebalancing speed, transaction costs incurred while rebalancing, and how the fund manages the remaining allocation. You still need to check the fund's actual tracking error separately.

Where can I find a fund's current tracking error and tracking difference? Both are published in the Scheme Information Document (SID), Key Information Memorandum (KIM), and monthly factsheets available on the AMC's own website, as well as on AMFI's website. SEBI requires this disclosure on a rolling basis, so it's updated regularly rather than being a one-time figure.

Is a fund with 0% tracking error better than one with a small but consistent tracking error? In practice, zero tracking error essentially doesn't happen due to costs, cash drag, and rebalancing lag. What matters more is consistency, a fund with a small, stable tracking error year after year is generally doing its job better than one with volatile readings, even if occasional yearly readings look similar on paper.

Does the 95% rule apply to debt index funds and gold/silver ETFs too, or only equity index funds? The 95% investment floor for index funds and ETFs, and 95% for fund-of-funds in underlying funds, applies as a general rule under the 2026 regulations across index-tracking passive products. Separately, gold and silver ETFs also saw a valuation methodology change from April 1, 2026, moving to domestic exchange spot prices rather than international benchmarks, which is a distinct but related move toward tighter passive-fund discipline.

Should I switch out of an index fund I already hold because of this new rule? There's no indication that existing, actively-managed index funds require you to switch. This rule affects portfolio construction requirements for AMCs going forward; existing fund houses are expected to already meet or be adjusting to meet the standard without disrupting current unit holders. If you do want to compare, use it as an opportunity to check your fund's tracking error and expense ratio against peers tracking the same index, not as a signal that your current fund is necessarily non-compliant.

The bottom line

The 95% rule is a genuine, structural improvement; it closes a real gap that lets some passive funds drift further from their index than the "passive" label implied. But it's a floor, not a scorecard. Every compliant fund clears the same minimum bar; what separates a good index fund from a mediocre one within that floor is still tracking error, tracking difference, and expense ratio, numbers you have to look up individually rather than infer from regulatory compliance alone.

Before your next index fund purchase or SIP top-up, pull those three figures from the fund's latest factsheet and compare them against at least one other fund tracking the same benchmark. That five-minute check tells you more about how well your money will actually track the index than knowing the fund meets the new regulatory minimum.

Sources

Disclaimers

This article is for general informational purposes only and does not constitute investment or legal advice. SEBI regulations, circulars, and compliance timelines are subject to change, amendment, or clarification, and the specific requirements described here reflect publicly available information as of the time of writing. Always verify current rules directly on sebi.gov.in or through the relevant AMC before making investment decisions. Figures such as expense ratio caps and tracking error limits are illustrative of the general framework and may vary by fund category or subsequent regulatory amendment.

Vijay InvestEdge is registered as a Mutual Fund Distributor ARN-1777. Mutual fund investments, including index funds and ETFs, are subject to market risks; please read all scheme-related documents carefully before investing. Past performance is not indicative of future returns. Nothing in this article is a recommendation to buy, sell, or hold any specific index fund, ETF, or fund house, and any references to specific tracking error or expense ratio figures are for illustrative and educational purposes only. Please consult a qualified financial advisor to evaluate which index funds suit your individual investment goals and risk profile.