COMMENT
Perfecting The Index Tracker

By Ed Bowsher (TMFArkle)
February 16, 2006

Prepare yourself for a shock. Make sure you're sitting down before you read any further. Yes, a writer at the Fool -- that's me -- admits that the venerable FTSE-100 tracker isn't perfect.

Don't get me wrong. The Footsie tracker has many virtues. It's cheap, it's simple and historically, it's out-performed the majority of actively managed funds. These are attractive qualities if you're looking for a long-term "buy and forget" investment.

But there are some defects.

Firstly, I suspect that if you buy a Footsie tracker, you will end up over-paying for some growth stocks within the index. That's what's happened in the US.

I picked up this idea from a lecture by Jeremy Siegel at a Fool.com conference last week. Siegel also outlines his theory in a recent book, The Future For Investors.

Siegel has researched the performance of the US S&P 500 index from 1957 to 2003. If you had invested $1,000 in an S&P tracker at the beginning of that period, your investment would have been worth $124,522 by 2003. That's an annual return of 10.85%, which is great.

However, Siegel claims that you would have done even better had you invested in the original constituents of the S&P in 1957 and stuck with them. You wouldn't have sold when companies were ejected from the index, and you wouldn't have bought when new companies came in.

Indeed, Siegel claims that his "total descendants" portfolio would have delivered an annual return of 11.4%, giving you $157,029 at the end of the period. (The total descendants portfolio includes companies that merged where you would have taken shares in the new entity. You would also have kept shares in businesses that were spun out of the original S&P constituents.)

Siegel doesn't dispute that new technologies and businesses boost economic growth. He just thinks that investors over-pay for growth businesses. If a value share is relatively cheap, its dividend yield will probably be high. If you reinvest dividends in the value share, you should get an attractive investment return in the long-term.

The problem of over-paying for growth can be accentuated by tracker funds' need to buy shares in a company as it enters an index. In the 2000 boom, grossly over-valued technology companies such as Baltimore entered the Footsie. They then became even more over-valued as the trackers were obliged to buy shares. Baltimore's share price plunged in subsequent years and it was eventually delisted on Valentine's Day in 2005.

One way to reduce your exposure to growth shares is to invest in the iShares FTSE UK Dividend Plus fund. It tracks the 50 highest yielding shares in the FTSE 350 index and is explained further in this article.

Another issue is that a small number of investment sectors now dominate the Footsie. Oil and gas, banks, and pharmaceuticals account for half of the Footsie by value. A "buy and forget" investor might imagine that a Footsie tracker gives him a diversified portfolio, but that's not the case. Even a FTSE All-Share tracker fund is still quite concentrated.

In response to this problem, FTSE has launched two new indices -- the FTSE Cap 100 5 per cent index and the FTSE Cap All-Share 5 percent index. No individual share can comprise more than 5% of these indices. The problem is I'm not aware of any fund that tracks these new indices. And even if there were such a fund, you're beginning to lose the simplicity that was part of trackers' attraction in the first place.

Overall, I'm still a fan of trackers, but they're not perfect. As with many things in life, it's all a bit more complicated than I once thought.

More: Looking For Fund Winners