I’ve been seeing a lot of talk about making regular contributions to index tracker funds. Investing in a fund tracking the S&P 500 for the last 10 years would have seen my ISA triple. So, what are tracker funds, how do they work, and is there a catch?
What is an index?
An index tracking stock markets is a value that represents the performance of the total valuation of a collection of companies. For example, the S&P 500 is an index that tracks the value of the largest 500 companies listed on US stock exchanges.
Typically, larger companies will be given a bigger proportional influence in the movement of an index.
What is an index fund?
An index mutual tracker fund or an exchange-traded fund (ETF) will hold portions of shares in all the companies currently in an index proportional to the weights.
To illustrate, a £500m index fund could have £500m invested into companies in the tracked index. It will therefore rise and fall in line with the index.
My £100k growth strategy
The Vanguard S&P 500 ETF (LSE:VUSA) is a liquid, low-cost exchange-traded fund tracking the S&P 500 index. ETFs are publicly traded on an exchange. New shares are created and dissolved as needed to match demand.
I can easily buy the Vanguard S&P 500 ETF in my Stocks and Shares ISA so that any gains are protected from tax.
The S&P 500 index over the past 100 years has annualised average returns of 9.6% accounting for likely dividends paid, management fees, and inflation associated with a tracker fund. With such a well-established track record, a similar rate of return could be achievable in the long term going forward.
Investing £5,000 into my chosen S&P 500 ETF and leaving it for 33 years could achieve £103,000 with 9.6% average annual returns.
Adding consistent monthly contributions of £200 could make that figure £109,000 in just 16 years!
Potential obstacles
This is certainly no “get rich quick” strategy. However, a financial advisor would still tell me this is a high-risk approach to investing my savings.
This is due to the volatility I am likely to witness in the value of my investment over the years. For example, holding the Vanguard S&P 500 ETF from 1998-2003 would have given me a -10% year-on-year return.
Losing patience and confidence during a sustained slide in the US stock market could quickly turn my projected £100k into a loss on my initial investment. This is where using a costlier actively managed fund could be more beneficial to me to help smooth out my gains and manage my expectations.
Conclusion
Investing in the performance of an index like the S&P 500 is like investing in the US equity market average. To do better than the market average would require skill, time, and competing against institutions. Even professionally managed funds have no guarantee of outperforming the average.
Market indices across the globe are starting to slide. So, I’m considering accumulating index ETFs to build capital over time and taking advantage of compounded potential average returns. However, it is not something that I plan to rely on as past performance is not to be relied on.
