We explain the advantages of investing in low-cost tracker funds, how to pick them and where to buy them
Why are tracker funds also called ‘index’ funds?
An index is made up of a number of stocks and shares – it goes up if the aggregate performance of those shares is up, and vice versa.
There is at least one index for each stock market. For example, the FTSE 100 is an index that represents the biggest 100 UK companies, and the FTSE All-Share represents all the UK companies listed on the London Stock Exchange. More obscure indices, made up of bonds or commodities, also exist and can be accessed by investors.
Changes in the shares’ value are averaged to create the index. This gives a picture of how the overall market has changed. Tracker funds give you immediate access to the entire range of companies or bonds in an index.
To track an index, tracker funds buy all the companies in an index, or a representative sample.
This approach is known as passive management, in that it aims to reflect the market, unlike active management, which aims to beat the market.
Passive management can be significantly cheaper, impacting on returns (see below).
One potential downside of passive investing is that if an index is dominated by a particular type of company or sector and it takes a tumble, your investment will fall with it.
This happened during the banking crisis in 2008, when the FTSE 100 and many other indices were dominated by banks. An actively managed fund has the ability to move money tactically to avoid sectors that the manager thinks are overvalued.
How do trackers track?
There are two primary ways that passive investment funds mimic the performance of an index.
This is the process of buying all components of an index. For example, a FTSE 100 tracker fund will buy shares in all 100 companies in the index, in proportion to size of the companies within the index. This means that funds can mirror the performance of the index as closely as possible.
When it is difficult to buy all the shares in an index, some passive funds invest in a sample of an index that is generally representative of the whole index.
A good example of this is the MSCI World index. This comprises more than 1,600 companies from 23 countries. The time and cost it would take to hold all the companies in the index for full replication could be detrimental to the portfolio.
Instead, partially replicated passive funds will purchase a sample of the companies that are most representative of the index itself.
- Find out more: why you need a stocks and shares Isa
How much do tracker funds cost?
Tracker funds are generally cheaper than actively managed funds.
This is because following an index is much simpler than having a team of fund managers and researchers continually pick shares.
Whether passively managed funds perform better than active funds is an ongoing debate, and comes down to the individual funds, but the difference in fees is significant.
Tracker funds can cost as little as 0.1%, while most actively managed funds cost between 0.5% and 1.5%, according to Morningstar.
That difference might not seem huge, but over time those costs will add up. Also remember that you’ll have to pay fees come rain or shine and an expensive fund will make a bad year even more painful.
Here’s how £1,000 in a fund costing 0.1% and a fund costing 1% would perform in three different investment performance scenarios, ranging from poor (5% loss), to neutral (0% growth) to good (5% growth):
Note: example for illustration only. Assumes consistent loss or growth each year.
What are exchange traded funds?
Exchange traded funds (ETFs) are a type of tracker fund which are listed on a stock exchange, so you can buy or sell them any time the market is open.
ETFs can be more transparent, liquid (meaning you can move money in and out of them easily) and flexible than unit trusts and OEICs.
They tend to be passive investments, making them relatively cost-effective. But bear in mind that some ETFs are actively managed and will charge higher fees to reflect this.
Also, because ETFs are traded on the stock exchange, they may carry trading fees. If you buy and sell ETFs frequently, these fees can stack up.
The emergence of ETFs has enabled investors to get access to markets and assets previously unavailable. Today, investors can choose from sector ETFs, bond ETFs, commodity ETFs and more.
Remember that a ETF that tracks a specific industry, like the energy sector, is likely to be more volatile than an ETF that tracks a broad market index like the S&P 500.
Synthetic ETFs don’t invest in actual shares or buy and store actual commodities.
Instead the ETF will enter into an agreement with a third party investment bank (a counterparty) to swap the performance of a basket of investments in exchange for the exact return of the stock market or commodity it’s tracking.
This is a type of derivative contract, involving extra risks. If the third-party investment bank were to fail, some of the investment could be lost.
It is important to note that many ETFs and ETCs aren’t domiciled in the UK. Therefore, they are not subject to the Financial Services Compensation Scheme (FSCS).
- Find out more: how to build an investment portfolio
What can tracker funds invest in?
Tracker funds can play an important role in building a diverse portfolio, because they come in all shapes and sizes:
There are tracker funds to suit almost every risk appetite.
This is because they can invest in higher risk shares (equities), as well as lower risk investments such as corporate bonds and gilts.
The best way to judge risk is to look at what the fund invests in. You can also look for the terms ‘cautious’, ‘balanced’ or ‘aggressive’ in a fund’s descriptions, although these descriptions aren’t exactly scientific.
Asset classes and sectors
You can track a huge range of indices, from the FTSE 100 to gold, oil, natural gas and even lean hogs.
Some asset types can’t be tracked, however, such as property, where you’ll need to use an actively-managed fund. In more specialised areas such as technology, healthcare. smaller companies or emerging markets, the expertise of a fund manager may come in useful
You can buy tracker funds that track specific indices within countries; entire regions, such as Europe; ‘developed’ and ‘emerging’ markets; or truly global funds.
This can be far simpler than buying shares yourself in other countries, which can involve extra paperwork and withholding taxes levied by foreign governments on your gains.
What makes a good tracker fund?
The best way to judge the performance of a passive investment fund is to look at its tracking error. This shows how far the fund’s performance deviates from the actual index it’s tracking.
Of course, no tracker fund will identically match an index, as an annual fee is levied on the funds. A tracking error of 0% would mean perfect replication. A tracking error that is just the cost of the fund is an indicator of an excellent passive investment.
ETFs generally have a better tracking error record than tracker unit trusts and OEICs, and synthetic ETFs generally improve on this further. But, as we have explained, these options can come with extra risks that you might not be comfortable taking.Where can you buy tracker funds?
Although you can invest directly in some funds, it’s far easier to buy them through an investment platform.
We’ve reviewed the major investment platforms; you can find our Which? Recommended Providers here.
Investment platforms also enable you to invest through a stocks and shares Isa, junior Isa or lifetime Isa, shielding you from tax and, in the case of the lifetime Isa, providing extra benefits. You can also hold tracker funds in a self-invested personal pension.