For those seeking to gain long-term exposure to equities, one of the simplest and cheapest ways is via an index tracker. Inexperienced investors should learn to love them because they enable one to invest without having to become an expert stock-picker or to pay the fees of an active fund manager.
What Is Index Tracking?
Index tracking is a simple strategy that involves investing in all the companies quoted on a particular index with the aim of replicating how the index performs.
For example, if you buy a FTSE 100 index tracking fund, you are investing in the largest 100 companies (by market capitalisation) on the London Stock Exchange, i.e. every company in the FTSE 100 index. Your investment should then closely match the performance of that index. If the FTSE rises by 20%, your investment will increase by 20% too (less fees). Of course, the reverse would also be true when the FTSE falls.
If you don’t have the time, skill or inclination to pick your own stocks, index trackers are a logical option. Warren Buffett pointed this out in his 1993 annual letter:
"By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."
The Pros…
The main benefit of trackers over active funds, i.e. those run by fund managers, is that their annual costs are generally much lower. This is because there is no need to pay for the expertise of a fund manager or to hire research staff, while transaction costs are also lower as fewer shares are traded.
Lower fees mean that more of the investor’s assets is going into the stock market, thereby leading to a better personal rate of return than if a greater portion of those assets were lining the pockets of a management firm.
A further benefit is that you can obtain wide-ranging diversification through trackers, thereby minimising company-specific risk.
The Cons…
It should be remembered that you cannot avoid general market risk and if the market falls so will the value of your tracker. Likewise, you cannot choose what’s in your tracker: it mimics the index, therefore if there is a handful of ‘bad’ companies included in that index, you’re buying them as well as the ‘good’.
Finding the Right Index Tracker
When comparing trackers for a particular index, Hortense Bioy, director of passive fund research at Morningstar Europe, advises that you examine the following four criteria:
1. The total expense ratio (TER). This is a combination of the fund’s annual management charge and its administrative charge and is designed to capture the full cost of owning the fund. Costs eat into returns, so investors should seek out suitable funds that offer low-cost fees.
2. The initial charge. As with actively managed funds, some trackers have an initial charge, or dilution levy—an upfront payment that must be made alongside the initial investment.
3. Tracking difference (TD). TD is defined as the total return difference between the fund and its benchmark index over a certain period of time, for example, one year. It represents the underperformance (or cost) an investor suffers when investing in a specific tracker, in comparison with the benchmark index. Conversely, it can also measure the overperformance that an investor benefits from when investing in a specific tracker compared to the benchmark index.
4. Tracking error (TE). This measures volatility and how closely a fund follows its benchmark. No tracker fund will ever perfectly replicate the performance of an index because of the practicalities of portfolio construction and ongoing management. The lower the tracking error, the more closely aligned your own investments will be with your chosen index.
Between items three and four, for a buy-and-hold investor with a longer investment horizon the tracking difference is more important. For a tactical and short–term investor, tracking error might be a more critical consideration.
Which Tracker?
The role an index tracker can play in a portfolio very much depends on the index it tracks and an investor’s goals.
“There are various ways you can use index trackers. They can be used to gain long term exposure to a specific market. They can also be used as tactical tools to overweight an index,” Morningstar’s Bioy explains.
It is possible to buy a multitude of trackers that follow equity and fixed income indices in the UK and globally. For example, if you want exposure to virtually the whole of the UK equity market you could choose one that tracks the FTSE All-Share index. Alternatively, you might select one that gives you exposure to emerging markets or the S&P 500, or even listed companies globally via the MSCI World Index.
