The Motley Fool

Choosing An Index Tracker Fund

Choosing an index tracker fund is relatively simple. There are four main things to consider:

  • which index it tracks
  • its charges
  • what type of fund it is
  • whether to put it in an Individual Savings Account (ISA)

1. Which index?

Most UK trackers follow either 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, and they make up about 80% of the UK stock market. The All-Share covers around 600 companies and about 98% of the market.

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 telecommunications.

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. However, there is nothing stopping you building up a small collection of different trackers over time, or just taking the simple option of buying a global tracker.

2. Charges

The lower the better. Most trackers have no initial or exit charge, so you really only need to look at their annual charges.

It’s best to look at the Ongoing Charges Figure (OCF) when comparing funds — this is an industry term meaning all the annual charges levied by a fund, rather than just its headline annual management charge. You might sometimes see this called the Total Expense Ratio (TER). There are some technical differences between these two definitions (the OCF includes any performance-based fees, for example), but for the purposes of comparing index tracking funds they should be very little, if any, difference.

For a tracker that invests solely in UK companies look for a total annual charge of 0.25% or less. These days, some funds can even go as low as 0.1%.

At the other end of the scale, you may find some trackers have annual charges of around 1%, which means that they have a much smaller cost advantage when compared to managed funds. These are best avoided, in our view.

For a tracker that follows a non-UK market, however, you might have to pay a little bit extra. That said, index trackers that follow the US market can just as cheap as those that track the UK. European or Asian trackers will probably cost a bit more, and trackers that follow a specific country or sector will also cost a little more.

You can even get index tracking funds that track global markets, and these are often a very cheap way of holding the broadest possible range of companies at an annual cost of around 0.25%. Bear in mind that this will mean around 50% of the fund is invested in US companies, given the very large size of this market compared to the rest of the world. The euro zone will make up around 10%, and the UK just 7%.

3. Which type of fund?

We’ll look at different types of fund later on in this guide, but it’s worth highlighting a few points at this stage. Most index trackers are either unit trusts or OEICs (open-ended investment companies). These are the most popular types of fund. They are priced daily and can be bought direct from a fund manager, or via a discount broker or financial adviser.

Other types of fund worth looking at are investment trusts and exchange traded funds (ETFs). These two types of fund are both traded on the stock market and therefore their prices will change continously throughout the trading day. They can be bought via a stock broker.

As a general rule, investment trust and ETF trackers tend to be slightly cheaper than unit trust or OEIC ones, so they are definitely worth considering.

4. Using an ISA

ISAs protect your investments from both income and capital gains tax. It’s often worth putting your tracker fund into an ISA to get this protection because there is usually no extra charge for doing so.

Higher rate taxpayers and those who use their full ISA allowance each year have to most to benefit. But even if you invest as little as £100 a month, several years down the line you could find the tax protection comes in handy.