Fool's Eye View

[ January 19, 2000 ]

The Trouble with Trackers?

By Alan Oscroft (TMFAlan)

Bournemouth, Dorset -- Fools, do you ever have one of those moments of realisation when, having spent a little while wondering what someone is going on about, you suddenly realise that they have, in that classically English way, unearthed the, err, jolly obvious.

I had such a moment yesterday when I was sitting leafing through last week's Investors Chronicle. I was reading an article about the hidden risks of investing in tracker funds, and what they were saying seemed so utterly inconsequential that I struggled to comprehend what they were actually complaining about.

I thought it was worth examining the problem apparently unearthed, not because I have any axe to grind with Investors Chronicle, which I find to be a very useful publication, but simply because it an example of the kind of bogus argument against index trackers that the Wise keep dreaming up from time to time. When faced with such arguments, Fools need to understand the basis of them and to be able to deduce the actual truth rather than just taking them at face value. The "problem" then, goes something like this...

An index tracker fund, as we all know, tracks a specific stock market index. Many UK trackers track the FTSE 100 index, and the amount of money invested in the fund is split across all 100 companies that make up that index, weighted according to the relative market capitalisation of each company. Tracking the All Share index doesn't make very much difference, because the FTSE 100 companies make up a very large proportion of it. If BP Amoco (LSE: BPA), for example, makes up nearly 9% of the total value of the FTSE 100 (which it does) then nearly 9% of the money invested in a FTSE 100 tracker will, in fact, be invested in BP Amoco. Sound OK so far? No obvious problems?

OK, let's continue. British Telecommunications (LSE: BT.A) makes up about 7% of the FTSE 100 at the moment, with the index being fairly significantly dominated by four main sectors, Telecommunications, Banks, Oil & Gas, and Pharmaceuticals in descending order of market capitalisation. These four sectors, when combined, account for more than 50% of the FTSE 100. Still sound OK?

Now, the problem, or so many of the Wise will tell us at least, is that index trackers are therefore exposed far more to volatility in those largest sectors than in the smaller sectors. If the big four sectors go through an unusually volatile period, then our index tracker will go with them. Are there any examples of this? You bet there are.

Investors Chronicle points to the share price of BT over a four-day period (yes, just a four-day period) in which it fell from over £15 to around £12. This, apparently, locked FTSE trackers into a "hair raising ride" as BT's 7% share of the FTSE 100 caused the trackers to fall alongside. Choosing this very short term fall, of course, misses several key points. Firstly, that £15 BT share price was an all-time high, and our index trackers wouldn't have been up there in the first place if they hadn't had 7% of their funds in BT. And secondly, a fall in the FTSE 100 over such a short period as four days is so utterly unimportant over the long term (which Foolish investors should be looking at) as to be laughable.

This particular example, I think, is a great example of how the evidence can be made to fit whatever hypothesis you want it to, providing a sufficiently small and unrepresentative sample is taken. Just how easy is it to pick whatever company or strategy you don't like and, with the benefit of hindsight, find a four-day period during which that company or strategy would not have done well? Easier than falling off a log, I would have thought.

Investors Chronicle goes on to say that last week's market fall highlighted a "sinister threat posed by trackers: that investors have no control, and possibly no regularly updated knowledge, of the risk they are taking in terms of their exposure to individual stocks or sectors." Sinister threat? Give us a break. Many active fund managers, we are told, would not invest as much as 7% in BT.

But as Fools know, managed funds provide investors with far less transparency than trackers, not more. People who invest in an index tracker know exactly where their money is, and can easily work out what proportion of it is invested in which companies and sectors. And we can do this whenever we please. How often can that be said for managed funds? Once or twice a year, perhaps, when the fund managers deem us worthy of knowing what they've been up to with our money for the past six months.

All these theoretical arguments that the Wise like to throw up against the use of index trackers are just not supported by real evidence. If the ability to avoid "over exposure" to certain large sectors gives active fund managers an advantage, then we should expect to see the majority of them outperforming the index, shouldn't we? But we don't. More than 80% of active fund managers underperform the trackers. And they expect us to pay through the nose for it. Some advantage, eh?

And that "jolly obvious" bit I mentioned earlier? Well, it suddenly struck me that arguments of this kind against the use of index trackers (and we hear such arguments from many Wise quarters) are effectively just saying "You know, the trouble with index trackers is that they track the index."

Thoughts, please, on the Fool's Eye View message board. And keep watching out for those "sinister threats", Fools.