- What is a tracker fund?
- Different index tracker funds
- What can tracker funds invest in?
- How do tracker funds work?
- Unweighted index
- Weighted index
- To weight or not?
- How do trackers track?
- Full replication
- Statistical sampling/partial replication
- How much do tracker funds cost?
- Do index tracker funds pay dividends?
- Are tracker funds a good investment?
- How to choose an index tracker
- 1. Choose an index
- 2. Choose the dividend policy
- 3. Look at the fund fee
- How to invest in a tracker fund
- Is now a good time to invest in tracker funds?
- What is the best FTSE 100 tracker fund?
- Should I invest in a tracker fund?
Tracker funds were first introduced in the US in the 1970s. They came to the UK in the 1980s and in the last decade or so, they have really taken off. They have become one of the most popular ways for private investors to get involved in the stock market.
But what exactly are these investment vehicles? How do they work? And should you consider them for your own portfolio?
Let’s break it down.
What is a tracker fund?
An index tracker fund is essentially a cheap, simple investment fund that mimics the performance of the stock market.
By owning tracker funds, your money will follow the price of an index up and down over time. You could also benefit from the excellent long-term returns of stock-market investing.
Different index tracker funds
There are literally hundreds of different indexes across the globe. As well as tracking the markets of whole countries, you can get indexes that track individual industries or large geographical regions like Europe or the Far East.
In the UK, the main indexes include:
- FTSE 100 – the largest 100 companies listed in the UK
- FTSE 250 – the 101st to 350th largest companies (often referred to as “mid-caps”)
- FTSE 350 – the 1st to 350th largest companies
- FTSE SmallCap – smaller listed companies that aren’t in the FTSE 350
- FTSE All-Share – the aggregation of the FTSE 100, FTSE 250, and FTSE SmallCap indexes — around 600 listed companies in total
Major US indexes include the Dow Jones Industrial Average (the Dow), the S&P 500, and the Nasdaq (where most technology shares are listed). Other indexes you may come across include the Nikkei (Japan), Hang Seng (Hong Kong), Dax (Germany), and CAC 40 (France).
Each index has its own rules, drawn up by the company that runs it, which specify exactly how it is calculated and when changes are made to the companies that constitute it. For example, the FTSE 100 has a reshuffle every three months to ensure that it continues to consist of the 100 largest companies listed in London.
But indexes also serve as a way for investors to compare their own portfolio’s performance. They can see if they are outperforming (doing better than the index) or underperforming (doing worse). Each index is made up of many different companies. The level of the index is calculated by taking an average of all its constituent companies’ share prices.
What can tracker funds invest in?
When you invest in an index fund, your money is pooled with other investors, and together you all then own a certain set of assets.
What investments sit in your chosen fund will be dictated by the particular index it is designed to track. You can get all types of indexes these days — some will follow companies listed on the stock market (like the FTSE 100, Dow Jones, or S&P 500), and others might follow government bonds or commodities like gold. The latter is often referred to as a commodity or bond fund.
How do tracker funds work?
Let’s imagine that the following are the biggest five companies on a theoretical stock market and that we want to create an index of them.
|COMPANY||SHARE PRICE||SHARES IN ISSUE|
|Deep Hole Mining||100p||40,000||40|
The market capitalisation is the figure for the total value of all the shares in each company. It is, therefore, the sum of the value of every shareholder’s shareholdings. So £400bn is the sum total invested in these five companies.
There are basically two types of indexes that people might try to make out of this: weighted and unweighted.
An unweighted index would give equal weight to the movements of each company. Each company would make up one-fifth of the index, and one-fifth of the index’s percentage movement is accounted for by each share.
So if Allied Pharma goes up 10% in a day, then the index will rise 2%. Similarly, if Exploration Oil moves up 10%, the index will also rise 2%.
If both Allied and Exploration rise 10%, then the index will rise 4%. If one rises 10% and the other falls 10%, then the index will be unchanged. You get the picture.
A weighted index gives different weights to the effect of each share’s movement on the index, according to how large its market value is, as a proportion of the market’s total value. Allied Pharma, with a market value of £160bn, makes up 40% of the index (£160bn being 40% of £400bn). So, if its shares rise 10%, the index will rise by 4%.
Exploration Oil, on the other hand, only accounts for 5% of the index. A 10% rise in Exploration Oil will, therefore, only increase the index by 0.5%. In other words, movements in Exploration Oil’s share price only have one-eighth of the effect on the index that movements in Allied Pharma have. This is because Exploration only has one-eighth as much money invested in it and is therefore only an eighth of the size of Allied Pharma.
The important thing about weighted indexes is that they reflect the average performance of every pound in the index. You can think of a weighted index as being like a portfolio that owns all the shares in all the companies. Whatever happens to the share price of the companies in the index, a weighted index matches the performance of the average pound invested in it.
To weight or not?
If we want a tracker that gives us the average performance of the market as a whole, then we need to be tracking a weighted index. For this reason, the majority of indexes are weighted. Examples from the UK include the FTSE 100 and the FTSE All-Share. In the US, the S&P 500 is a weighted index.
However, the Dow-Jones Industrial Average is an unweighted index. Other unweighted indexes are the FT 30 in the UK and the Nikkei 225 in Japan. Tracking these unweighted indexes would not necessarily give you anything like the average performance of the US, UK, and Japanese stock markets and therefore isn’t ideal.
How do trackers track?
An index tracker attempts to match the performance of a particular ‘index’ of shares. In other words, it attempts to follow the ups and downs of the index as closely as possible. It does this by exposing itself to the performance of the shares in that index.
There are two main ways that an index fund can track: full replication and statistical sampling, sometimes referred to as partial replication.
Full replication simply involves creating a stock portfolio that includes all the shares in the index at their relevant weights. So, if you were setting up a tracker fund with £4m to track the performance of the theoretical weighted index that we looked at above — which we’ll call the TMF 5 — then we would need to buy 0.001% of each company (that is, our fund of £4m as a proportion of the total value of the index of £400bn).
So, we’d buy the following:
|COMPANY||SHARE PRICE||SHARES PURCHASED||VALUE|
|Deep Hole Mining||100p||400,000||0.4|
Once we’ve bought these shares, then all things being equal, we can just leave the tracker to do its job. We basically only have to buy and sell the shares in three situations.
1. Index changes
The TMF 5 is designed to follow the performance of the average pound invested in the five biggest companies on our theoretical stock market. Say Exploration Oil shares did badly and were overtaken by Future Technologies in terms of market value.
The shares of Future Technologies would replace Exploration in the TMF 5 Index. We would therefore have to sell all our shares in Exploration Oil and buy shares in Future instead. We might also have to tinker with the overall weightings of all the stocks if our correctly weighted stake in Future Technologies costs more than we get for our Exploration shares.
In the UK, the FTSE indexes are rebalanced every quarter. However, some changes occur at other times when, for example, a company is taken over and its shares are no longer listed on the stock market. In this instance, the highest placed company on the ‘reserve list’ is normally promoted to the index.
2. Share capital changes
This is when the member companies issue new shares or cancel any of their existing shares. Imagine that Deep Hole Mining issued one new share for every four of its existing shares to buy the Australian company, Gold Diggers Pty Ltd. The TMF 5 would have to adjust itself to take account of this. Assuming that the market was ambivalent towards the deal and the share price of Deep Hole didn’t move, the new index would look like this:
|COMPANY||SHARE PRICE||SHARES IN ISSUE|
|Deep Hole Mining||100p||50,000||50|
So all the other companies’ weightings have fallen. For example, Allied Pharma’s weighting has fallen from 40% to 39% (160/410). Deep Hole’s weighting has increased from 10% to 12.2% (50/410). As a result, a little of each of the other companies will need to be sold and the money used to buy shares in Deep Hole.
3. New money from investors
The third reason for buying and selling would be if a new investor came along and asked to invest £100,000 in the tracker fund. In this case, we would have to add 2.5%. This frequently happens with most index trackers. Every day, people are coming along to put more money in or to take money out.
If there is a pound put in for every pound that gets taken out, the balance is maintained. However, if, overall, money is flowing into the fund, then it will need to be buying shares in each company each day to keep its correct exposures. If net cash flows out, then it needs to be selling shares in each company daily to maintain the balance.
Statistical sampling/partial replication
With an index like the FTSE All-Share (which consists of around 600 companies), full replication is likely to be extremely costly to achieve. To track these larger indexes, a process called statistical sampling is often used. The fund doesn’t try to hold every share in the index, but it analyses the index and works out its investments so that it is very confident of achieving a performance that is very close to it.
So, at a basic level, with the TMF 5, we might decide that, since Exploration Oil only accounts for 5% of the index’s value, we don’t need to hold it to ensure a performance very close to the index. We do, though, have to keep a close eye on it. Suppose it increases by 20% relative to the rest of the index. In that case, we will underperform by 1%, and we certainly don’t want to risk underperforming by more than that.
We might therefore decide that we can afford to save costs by not holding Exploration Oil unless and until it increases to a level where it accounts for 6% of the index. Of course, if Exploration Oil underperformed the rest of the index, then we would benefit from not holding it.
Statistical sampling is a bit of a fudge. Suppose money flows into the fund from new investors. In that case, shares of one sort or another will certainly have to be bought. Still, we might be able to save a bit on costs by not sticking rigidly to buying exactly the right amount of every single company.
With a large index such as the FTSE All-Share, the relationships between the different shares will be examined so that the tracker’s manager can be very confident of not departing very far from the index.
How much do tracker funds cost?
As an index fund almost runs itself, they are very low cost compared to active funds. In fact, most tracker funds are run by automated computers rather than professional fund managers. Furthermore, the make-up of most indexes doesn’t change much over time, so transaction fees are few and far between. As a result, the annual fee for these funds tends to be extremely low.
On average, the average annual management fee sits around 0.06%. This means for every £1,000 invested, a shareholder would need to pay approximately £6 a year.
That’s why tracker funds are often considered the simplest and most cost-effective way to invest.
Do index tracker funds pay dividends?
Yes. However, there are two different ways in which dividends are distributed to shareholders. The first method is to simply pay shareholders dividends as cash, much like any other dividend-paying stock would. These types of trackers are usually named income or distribution funds.
An alternative method is through reinvestment — sometimes referred to as accumulation. In other words, instead of paying shareholders, the fund will automatically reinvest any dividends received back into the stocks that pay them. This, in turn, causes the share price of the index tracker to increase.
Are tracker funds a good investment?
Investment funds can be split into two basic types. An active fund has a fund manager picking and choosing the shares on your behalf, getting paid handsomely for the privilege, we might add.
Then there is the passive fund that merely buys the whole market or a certain section of it. These are the index trackers.
Active sounds much more fun, doesn’t it? We all want to beat the market. By definition, before we take charges into account, half of our investment will do better than the overall market, and the other half won’t. But when you take off charges and transaction costs, you can see that it’s inevitable that, in most cases, an actively managed fund will underperform the market.
What this means is that most people are better off taking a passive investing approach by choosing a fund with low charges. And passive funds have the lowest charges.
In fact, studies have shown that over the long term (by which we mean over five years), index trackers tend to beat about three-quarters to four-fifths of managed funds.
Of course, there will always be some funds that do better than index trackers. The only trouble is identifying them in advance. Some people claim they can, although it’s much more difficult than you think. For one thing, oodles of research have shown that a fund’s past performance is no guide to its future performance.
How to choose an index tracker
Most index trackers are pretty similar in nature. But how does an investor pick between the vast collection of choices?
1. Choose an index
Here in the UK, the FTSE 100 is popular since it comprises largely mature, proven businesses delivering relatively reliable results. But for individuals more interested in growth and who don’t mind taking on more risk, the FTSE 250 may be a better candidate.
2. Choose the dividend policy
Most index trackers often have a duplicate version of themselves. The difference between them is the way dividends are handled — income/distribution or reinvestment/accumulation. If an investor is seeking to grow wealth, reinvestment may be a more suitable choice. For an investor looking to retire and live off some passive income, the alternative is likely more ideal.
3. Look at the fund fee
Some index trackers are more expensive than others. Fortunately, the vast array of choices makes finding a low-cost fund relatively easy.
How to invest in a tracker fund
Investing in a tracker fund is just as easy as investing in any business. Shares are listed on various exchanges around the world. And once an investor has decided which to buy, they simply need to place an order with their broker in their investment account.
For individuals seeking to commit to monthly recurring investments, most brokers offer discounted commission fees if a recurring purchase plan is set up.
Is now a good time to invest in tracker funds?
Tracker funds ultimately mimic the stock market. And as seen in 2022, the world of investing can be a volatile place. At least in the short term. But in the long run, share prices of strong businesses recover and then continue to reach new heights. Just look at where prices are today versus the 2008 financial crisis.
After a steep correction, plenty of stocks currently trade at discounted prices. And while the FTSE 100 has been largely immune to the 2022 volatility, the same can’t be said for other indexes like the S&P 500 or FTSE 250.
But with fear driving stock prices down, there are arguably fantastic opportunities to be had today. Therefore, while there is no knowing when this episode of market volatility will end, investing in an index tracker at current prices could be a highly lucrative decision in the long term.
What is the best FTSE 100 tracker fund?
There are numerous FTSE 100 tracker funds listed on the London Stock Exchange for investors to choose from. While these are largely identical, what differentiates them is the fees. So, here are the top five FTSE 100 index trackers in order of cost.
|Name||Fund Size||Annual Fee|
|iShares Core FTSE 100 (LSE:ISF)||£10.33bn||0.07%|
|HSBC FTSE 100 (LSE:HUKX)||£477.81m||0.07%|
|Vanguard FTSE 100 (LSE:VUKE)||£4.05bn||0.09%|
|Xtrackers FTSE 100 (LSE:XDUK)||£102.05m||0.09%|
|Invesco FTSE 100 (LSE:S100)||£15.69m||0.09%|
Should I invest in a tracker fund?
For many, choosing to invest in a tracker fund over individual stock picking is likely a suitable choice. After all, this process requires very little knowledge of the inner workings of businesses or the stock market. Pairing this with the added advantage of being able to leave the wealth-generating process on autopilot makes index investing an attractive proposition.
Alternatively, picking individual stocks is a tried and tested method of generating higher returns for those with more time and risk tolerance. It does require significantly more discipline, effort, and emotional control. And it’s why this style of investing is not for everyone. But all it takes is a few extra percentage points of returns to enormously accelerating the wealth-building process.