Confused about index trackers? We look at some common questions many people have about the Fool’s favourite type of investment fund.
Index trackers are many people’s first foray into the stock market. So it’s natural to feel a little bit nervous and to ask questions about what’s involved. Here are four common questions asked by first-time investors.
1. What costs should I consider?
There are a number of costs to be aware of when putting money into investment funds. Exactly what costs you’ll face will depend on whether your tracker is a unit trust/OEIC, investment trust or exchange traded fund (ETF). It’s worth understanding the basic differences between each type of fund although it’s not really necessary to delve into the finer details of how each type of fund works (unless you want to of course!)
Annual cost
The annual cost of the fund is the most important cost to consider. It’s a fixed percentage each year, however make sure you look at what is known as the total expense ratio rather than the headline management fee. The former includes all the costs borne by the fund and so is the one to use when comparing one fund against another. For example, for the L&G UK Index trust, the biggest tracker in the UK, charges a 0.5% management fee per annum and 0.02% in other expenses giving it a total expense ratio of 0.52%.
Stamp duty
When you buy most investments you pay 0.5% to the government in stamp duty (there’s no stamp duty when you sell). Exchange traded funds are an exception though as most funds used by UK investors are based in Dublin and therefore exempt from stamp duty.
Transaction costs
If you buy a unit trust/OEIC you typically don’t pay any transaction fees. It’s a little different for investment trusts and ETFs. You usually have to pay a broker’s fee of around £10 when you buy or sell. However, there are regular investment schemes, like the Motley Fool Sharebuilder, and dividend re-investment schemes which allow you to buy for as little as £1.50 a time. In addition, most investment trusts run their own share schemes which allow free purchases.
ISA charges
There’s typically no charge for unit trust/OEIC tracker funds held in an ISA. Most companies charge a small annual fee of around £25 for self-select ISAs that contain investment trusts or ETFs. Alternatively you could opt for a provider such as Alliance Trust which charges no ISA fee.
As a general rule, I reckon for regular investors investing small sums that unit trusts/OEICs will tend to work out cheaper. For those intending to invest larger sums, say £10,000 or more, ETFs and investment trusts will tend to be cheaper.
2. FTSE 100 or FTSE All-Share?
These are two main indices that track the UK market. The FTSE 100 covers about 80% of the market and consists of the 100 largest companies. The FTSE All-Shares is made up of around 650 companies and covers 98% of the market.
I marginally favour index trackers that follow the All-Share. The idea behind index tracking is to cover as much of the market as possible, so this is a plus point for the All-Share. And, even though All-Share trackers consist of more companies, they generally don’t cost any more to invest in than a FTSE 100 fund. Finally, since 1984 when the FTSE 100 was introduced, the FTSE All-Share has performed slightly better (by 0.3% a year on average if you exclude dividends).
3. What happens to dividends?
One thing that confuses many novice investors is what happens to the dividends paid out by the companies contained in the FTSE 100 and FTSE All-Share indices. They often assume that the tracker price follows the index but the fund management company keeps all the dividends!
This is not the case. Index trackers pay their own dividends, either on a quarterly or six-monthly basis. Typically the expenses of the fund will be offset against the dividends from the companies in the index. Say the companies in the FTSE All-Share pay out an average dividend of 4% a year and your tracker charges an annual fee of 0.5%. The dividend paid out by the tracker should be in the region of 3.5%.
4. Should I worry about tracking error?
As well as the cost of running a fund, due to the way the stock market works, it’s not possible for an index tracker to follow an index with perfect accuracy. Sometimes shares are not available in sufficient volume or it may not be cost efficient to own shares in the smallest companies in the index.
So each tracker will deviate from the index by a small amount and this is what is known as its tracking error. If you compare a fund’s performance against the index it tracks you can estimate it. Say your fund has returned 12% a year and charges 0.5%. If the index has returned 12.7% then the tracking error is 0.2% per annum.
Looking at the performance of most funds there is not a big difference in their tracking errors. There is also no guarantee that a low or high tracking error will persist over time. It pays to monitor your fund to see that it’s keeping up with the index once you’ve invested your money. But I don’t think it’s worth worrying too much about past tracking errors before purchasing a fund. It’s far more important to focus on its annual cost.
You can invest in L&G’s range of index trackers through the Fool.
More articles on index trackers: Cheapest UK trackers | Cheapest foreign trackers | Four index tracker myths
