Should you track the market?

Tracker funds were the only retail funds to see an increase in net inflows in the first three months of 2012, according to the Investment Management Association (IMA). The IMA figures showed that index-tracking, or passive, funds saw a 25.2 per cent increase in net retail sales to £661 million compared with the first quarter of 2011, a record high since IMA’s analysis began in 1992. This while overall net fund inflows plummeted by 38 per cent to £3.8 billion over the same period, mainly led by a 77 per cent plunge in fund of fund sales

Tracker funds now make up 7.1 per cent of total IMA funds under management (FUM), while its share of gross retail sales was 5.6 per cent, higher than in recent quarters

What is an index tracker fund?

A tracker fund owns the same shares (and in the same amounts) as the index it tracks, and thus tries to mirror the performance of that index. An index tracker is different from a managed fund because the person who manages the index tracker is a passive investor. They simply follow the index — they don’t have any input into which shares the fund owns

Of the 81 tracker funds now in the IMA universe, 39 (48 per cent) track either the FTSE 100 or the FTSE All Share indices, while the others are spread out globally, including US and European index trackers

Why should I buy one?

There’s long been a debate about the relative effectiveness of active (managed) versus passive (tracker) funds. Proponents of the latter claim they have the following advantages:

1. They’re easy to understand - An index tracking fund replicates - or ‘tracks’ - the performance of an index by investing in all the shares quoted on it. For example, a FTSE 100 index tracker will invest in every one of the top 100 UK companies. This means if the FTSE 100 rises by 5%, the value of your investment will increase accordingly (with a deduction for fund charges and a tracking error - which represents how closely the fund matches changes in the index). Equally, if the FTSE 100 drops by 5%, your investment will drop by roughly the same amount

It’s as simple as that. All you need to do is decide which index you would like to track. For example, you can stick to the home market if you wish. If you want an investment that covers the majority of UK listed companies, choose a FTSE All Share tracker - rather than one based on the FTSE 100 - and you’ll gain exposure to around 98% of the market. It’s also possible to invest in trackers globally which replicate indices overseas

2. They’re cheap

Index trackers are ‘passively managed’ which means there’s no fund manager actively picking stocks to invest in, as this decision is completely determined by the companies that come onto the index, or fall off it. There are different ways of tracking, but commonly the amount invested in each company will equate to the proportion of the index it comprises. In other words, the most money will be invested into the largest companies

Because there’s no active fund manager - the index tracking strategy can be achieved by computer - the fund charges are significantly lower with no investment expertise required. In fact, the cheapest trackers available to the UK investor take an annual management charge of just 0.15%. This is the charge applicable to the FTSE UK Equity Index fund from Vanguard Investments. There’s a whole raft of tracker funds which charge 0.5% or less

Actively managed funds, in contrast, advertise annual charges of 1.5 per cent  (and more) but the ‘total expense ratio’ or TER on an actively managed stock market fund is normally closer to 1.7 per cent. That would gobble £170 a year on a £10,000 ISA. The effect of these charges compounds over the years so that after 10 years of 6 per cent growth £10,000 invested in the Vanguard tracker would grow to £19,378 compared to £16,594 for a fund with 1.7 per cent fees

Remember, any index tracker with a significantly higher charge is effectively ripping you off since all trackers which invest in the same index are essentially doing the same thing. A fund with annual charges of 1% is very expensive

3. They’re affordable

Index trackers are also great for smaller investors since many funds require a relatively low monthly contribution from you. If you’ve got say, £50 a month available, you should find plenty of trackers which will accept this level of investment. Of course, trackers will be able to accept payments from larger investors too

4. They beat many actively managed funds

You might think a passively managed fund couldn’t possibly perform as well as a fund with an active fund manager. But you’d be wrong. Picking the right stocks is an incredibly difficult task, and even the experts make the wrong calls on a regular basis

In fact, index tracking funds have been shown to regularly outperform managed funds. But, don’t forget, you can only expect returns which closely match how the stock market is doing as a whole. A handful of the top performing funds are capable of beating the market, but you will have to pay higher charges for the benefit of the manager’s stock picking prowess

You should also bear in mind that the top funds today may not continue to be the star funds of tomorrow. But, with an index tracker, you’ll have an investment which always generates returns more or less in line with the market

5. They can be invested tax-efficiently

You can boost the returns from your tracker fund even more by holding it within a pension or ISA wrapper. That way, your investment will grow completely free of both income and capital gains tax. You can save up to £50,000 a year into a pension to plan for your retirement. Meanwhile, under current rules, you can invest a maximum of £11,280 into a stocks and shares ISA

You can hold a tracker alongside other investment funds to diversify your pension or ISA portfolio. Index trackers can also be held as direct investments outside pensions and ISAs, but then any capital growth earned will be taxable when you take a profit

6. They won’t take up your time

Lastly, as you’ve probably realised by now, you don’t need to be an investment whizz to pick a decent index tracker. Nor do you need to spend your precious time seeing how particular sectors or shares are performing before diving in. All this is done for you, making trackers the perfect choice for novice investors, or those with limited time to spend monitoring their portfolio

The downside of trackers

Some people believe that tracking an index results in imbalance; for example, around 40 per cent of the FTSE 100 Index is made up of banks and other financial shares.  If this sector should go through a bad patch, the index would suffer accordingly. A traditional fund manager who saw this coming might have been able to sell some of these shares and buy other ones instead

A tracking fund cannot do this, it must hold shares in the companies that make up the index

The global viewpoint

Research suggests that trackers are far more effective in ‘efficient’ markets, such as the UK and the US. One reason advanced for this is that in those countries, financial systems ensure that everything investors need to know is in the public domain and well reported. Therefore, it’s harder for a fund manager to seek out bargain stocks that have been overlooked and he or she will struggle to beat the index

But in less efficient markets, such as countries in the Far East, stock-pickers find it easier hunt out gems and therefore find it easier to beat trackers

Is a tracker for me?

As with any investment strategy, you should adopt the safety-first philosophy: don’t put all of your eggs in one basket. The low charges and simplicity of a tracker fund make it an ideal core holding in your portfolio. You can then use more traditional funds to build on that base

Which tracker?

Once you’ve decided which index you want to track, then, broadly speaking, it’s more or less a case of choosing a fund with the lowest charges. Hargreaves Lansdown is a good starting point

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May 16, 2012

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