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Choosing an Index Tracker

Which index tracker ISA (individual savings account) is best for you? The Motley Fool shows you how to choose an index tracker based on charges, which index it tracks, and tracking error.

Choosing a tracker is actually quite simple. You need to look at three things.

  • Charges
  • Which index to track
  • Tracking error

Charges

The lower the better. Most trackers have no initial or exit charge. Few have annual charges of over 1% and some are as low as 0.3% to 0.4%. Some companies will split their annual charges into two or more categories and only quote one of them in their adverts. So always make sure you check the Key Features document that has to accompany every application. This will show you all the charges.

Which index?

Most UK trackers follow the FTSE 100 or FTSE All-Share. Both these indices cover shares listed on the London Stock Exchange. The FTSE 100 covers the largest 100 companies by market value. The All-Share covers the top 800 or so. You can also buy trackers that follow European, US or Far East indices. There are even some that track world indices. You can also get funds that track specific sectors like technology, health or telecoms.

It's impossible to predict which of these indices will do best. Many people recommend that you diversify your investments internationally but a significant percentage of the profits from UK companies comes from abroad anyway. Consequently a cheap UK tracker following the FTSE 100 or FTSE All-Share is a sensible starting point. Trackers that follow other indices tend to be more expensive. However, there is nothing stopping you having a small collection of different trackers, perhaps a different one each year.

Tracking error

The tracking error measures how closely a fund tracks its chosen index. No tracker is able to exactly match the index because it is not always possible to buy and sell enough shares at the exact same time that the index changes. However, most funds will be fairly close. Some funds will publish their tracking error. In other cases you can estimate it yourself by comparing the performance of the fund against the performance of the index. The difference between the two will be the combination of charges and tracking error. It makes sense to stick with trackers that have been around a few years as, having had more practice, they are likely to be better at minimising their tracking error.

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