A Simple Guide To Tracker Fund Investment

Tracker funds, also known as index funds, are a form of passive investing. They are designed to replicate the performance of a market index, such as the S&P 500 or FTSE 100. Tracker funds are a low-cost way to gain exposure to a broad range of shares or bonds, and they are run using computer algorithms rather than costly research and managers. This makes them a cost-effective option for investors. However, it's important to note that tracker funds will never outperform the market or index they are linked to.

Tracker funds vs active funds

Tracker funds, also known as index funds, are a type of passive investment. They aim to replicate the performance of a particular market index, such as the S&P 500 or the FTSE 100, by purchasing all or a representative sample of the holdings in the index. This provides investors with a well-diversified portfolio at a low cost, as there are no fund managers or analysts to pay.

Actively managed funds, on the other hand, attempt to beat the market by having a fund manager hand-pick investments based on in-depth analysis. The potential to outperform the market is an advantage that actively managed funds have over tracker funds, and this is attractive to investors.

However, evidence shows that it is difficult for actively managed funds to consistently outperform their relevant index. For example, a Vanguard study found that for the 10 years ending June 30, 2020, 180 out of 205 Vanguard funds outperformed their peer-group averages. Additionally, the average ongoing management expense of an actively managed fund is 1% more than that of a passively managed fund, which compounds each year and gives passively managed funds an advantage over the long term.

Actively managed funds also tend to buy and sell their underlying investments more frequently, resulting in taxable capital gains for the fund shareholders. This buying and selling, known as "turnover", is an additional handicap for actively managed funds to overcome.

In summary, tracker funds offer a simple, low-cost way to invest, providing instant diversification by tracking the performance of a particular market index. Actively managed funds, on the other hand, aim to beat the market through hand-picked investments but come with higher fees and more taxable capital gains. The choice between the two comes down to an investor's individual circumstances, risk tolerance, and investment objectives.

Passive investing

Tracker funds are a type of passive investment fund that tracks a broad market index or a segment of one. They are designed to offer investors exposure to an entire index at a low cost. These funds seek to replicate the holdings and performance of a designated index. Tracker funds are also known as index funds.

Index funds are driven by tracking functions, and tracker funds seek to replicate the performance of the market index. Passively managed tracker funds can include customised indexes for market sectors, segments, and themes. Customised tracker funds provide more targeted investments while keeping overall expenses lower using an index replication strategy.

There are two main ways that an index fund can track: full replication and statistical sampling (also known as partial replication). Full replication involves creating a stock portfolio that includes all the shares in the index at their relevant weights. Statistical sampling, on the other hand, involves analysing the index and working out investments so that the fund is very confident of achieving a performance very close to it.

Overall, passive investments tend to be cheaper than their actively managed counterparts. The average annual management fee for a tracker fund is in the region of 0.05% to 0.2%, compared to 0.5% to 1% for an active fund.

Advantages of tracker funds

Tracker funds, also known as index funds, are a form of passive investing. They are designed to offer investors exposure to an entire index at a low cost. Here are some of the advantages of tracker funds:

Low Cost

Tracker funds are often available at an extremely low cost. They are cheaper than actively managed funds because they are run using computer algorithms rather than costly research and managers. The average annual management fee for a tracker fund is in the region of 0.05% to 0.2%, compared with 0.5% to 1% for an actively managed fund. This makes them a cost-effective option for investors seeking to build a diversified portfolio.

Instant Diversification

Tracker funds provide instant diversification by tracking the performance of a broad market index or a segment of one. This means that investors get exposure to a wide range of shares or bonds without having to buy them directly. For example, a Nasdaq 100 tracker fund will mirror the price movements of the companies in the Nasdaq 100 index, allowing investors to gain exposure to the US tech sector without having to buy individual shares in dozens of different companies.

Convenience

Tracker funds are 'passive investments', meaning that investors only need to buy shares in the fund itself. The fund provider takes care of choosing the assets that go into the fund, so investors don't need a high level of financial knowledge. Tracker funds are also convenient for investors who wish to reinvest income, as accumulation units are available that retain income within the fund for reinvestment.

Broad Exposure

Tracker funds usually offer broad exposure to the financial markets for lower upfront costs than buying each asset individually. They can track a range of different areas, from an individual sector to an entire stock market index.

Types of tracker funds

Tracker funds, also known as index funds, are a form of passive investing. They are designed to offer investors exposure to an entire index at a low cost. These funds seek to replicate the holdings and performance of a designated index. They are pooled investments used to track a broad market index or a segment of one.

Tracker funds can be structured as a unit trust, open-ended investment company (OEIC), or as an Exchange-Traded Fund (ETF). Unit trusts and OEICs are valued and dealt with the manager once a day based on the value of the underlying assets held by the fund. ETFs, on the other hand, are bought and sold on the stock exchange at any time throughout the day, much like shares.

While unit trusts and OEICs typically track major indices like the FTSE 100 or the S&P 500, ETFs track a broader range of areas, including niche industry benchmarks. This allows investors to invest in various specialist areas.

The majority of tracker funds are either income or accumulation units. Income is paid out to fund holders as cash, while accumulation units retain income within the fund for reinvestment.

Customized tracker funds are also available, providing more targeted investments. These funds use an index replication strategy to keep overall expenses lower while offering the benefits of active fund management through screened indexes.

How to choose a tracker fund

Tracker funds are a great way to get started with investing, allowing you to quickly invest in a particular country or region, or form the building blocks of a portfolio. Here are some key considerations for choosing a tracker fund:

Understanding Tracker Funds

First, it is important to understand what a tracker fund does and why you might want to buy it. Tracker funds, also known as index funds, aim to track the performance of a particular market index, such as the FTSE 100 or S&P 500. They are passively managed, meaning they simply replicate the composition of the index they are tracking. This is in contrast to actively managed funds, where the fund manager actively selects investments with the aim of beating the index's return. While actively managed funds may sound more appealing, it is worth noting that over the last 15 years, less than 50% of actively managed funds have outperformed their passively managed counterparts.

Which Index to Track

When choosing a tracker fund, the most important consideration is which index it tracks and whether it aligns with your investment objectives. Generally, broader and more diversified indices are preferable as they tend to have wider appeal. For example, if you are seeking exposure to the UK stock market, you could choose between the FTSE 100, FTSE 250, or FTSE All Share, each offering exposure to a different range of companies based on their size.

Fund Charges

After the choice of index, the most crucial factor to consider is the fund's charges. Costs play a significant role in determining the performance of a tracker fund. Over time, higher charges will have an increasing impact on the fund's performance, reducing your returns. Therefore, it is essential to compare costs between different tracker funds tracking the same high-profile indices to find the most cost-effective option.

Replication Method

Another important consideration is the method used to replicate the index. There are two main approaches: full replication and partial replication (also known as statistical sampling). Full replication involves the fund holding all the shares or bonds in the index, while partial replication means the fund chooses not to hold some smaller stocks. Full replication leads to more precise tracking but may be unfeasible or costly for indices with a large number of constituents.

Stock Lending

Finally, consider the fund's approach to stock lending. Stock lending involves the fund lending its holdings to a third party in exchange for a fee, which can help offset costs. However, it carries some risk, so it is essential to ensure that the fund manager takes steps to control these risks and that the benefits are passed on to investors in the form of lower fees.

Frequently asked questions