The Motley Fool

Choosing An Index Tracker Fund

Tracker funds, also known as index trackers, are one of the simplest and most cost-effective ways you can invest. 

They were first introduced in the US in the 1970s and came to the UK in the 1980s. Tracker funds have really taken off in the last decade or so, and have become one of the most popular ways for private investors to get involved in the stock market.

What is a tracker fund?

When you invest in an index tracker, your money is pooled with other investors’ into a fund, and together you all then own a certain set of investments.

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 indices these days — some will follow companies listed on the stock market (like the FTSE 100, Dow Jones, or S&P 500), others might follow government bonds or commodities like gold.

In fact, if you can think of an investment idea, there’s probably an index that will follow it and a tracker fund based upon that index. 

By owning tracker funds, your money will follow the price of an index up and down over time, and you could benefit from the excellent long-term returns that stock-market investing has provided.

As index trackers almost run themselves, they are very low cost compared to active funds, which is where you pay a manager (usually dressed in a very smart and expensive suit) to pick and choose investments for you.

The make-up of most indices doesn’t change much over time, so this also helps to keep your underlying costs down. 

While these may sound like small advantages, they compound massively over time. Research has repeatedly shown that over long time periods (five years or more), tracker funds tend to beat between 80-90% of actively managed funds.

In short, by owning tracker funds, it’s possible to beat the stock market professionals at their game, simply by buying them and then holding for the long term.

How a tracker fund works

There are a few nuances but most index trackers operate in a very similar fashion.

You can either buy them directly from the company that runs them (e.g. Vanguard) or can you buy them from an investment platform (e.g. Hargreaves Lansdown) that offers a wider range of tracker funds from lots of different companies.

They are two basic types: open-ended funds (sometimes you might see these referred to as UCITS funds) and exchange-traded funds (ETFs).

Open-ended funds are priced once a day (usually either at midday or late in the evening). The fund manager collects all the buy and sell orders it’s received and adjusts the fund’s holdings accordingly. You own a certain amount of units and the number of units is often calculated to several decimal places.

ETFs can be bought and sold on the stock market so you can trade them directly yourself, just like you would for the share of a publicly listed company. Their price will change (albeit usually by a very small amount) on a minute by minute basis. You will normally own a whole number of shares in an ETF, although some providers may offer what are known as fractional shares.

Which type of fund suits you best will depend on a variety of factors, such as the charging structure of the fund company or investment platform that you use, the amount you want to invest, and how regularly you want to add more money. 

As a very general guide, open-ended funds tend to suit those investing smaller sums and ETFs benefit those investing larger amounts or who want to trade more frequently.

It’s important to realise that the returns from a tracker fund will never exactly match the index it follows. Indices themselves don’t have any costs — they just reflect price movements — whereas tracker funds have to actually buy and sell, and they incur various admin and legal costs. 

But tracker funds are very cheap to run. Most charge 0.25% a year or below and some even charge less than 0.1% a year.

One other thing to be aware of is whether your tracker fund is physical or synthetic. This is usually mentioned on the tracker fund’s monthly factsheet or website.

Physical means your index tracker actually owns the underlying investments. Synthetic means it does so indirectly by investing in a related financial instrument like an option or derivative.

Physical tracker funds are generally considered lower risk, but the synthetic approach can be useful when investing in something more specialised, where it is more difficult or more costly to hold the underlying investments in an index. 

Some tracker funds might use a mixture of the two approaches.   

Choosing an index tracker

The first thing to decide is what sort of index you want to track.

For example, you might decide you want to invest in all the stock markets around the world. 

Global index trackers allow you to do this for a surprisingly low fee (a £1,000 investment might cost you as little as £1 or £2 a year in fund fees). Global tracker funds typically hold several thousand companies from the US, Europe, the UK, Asia, and so on.

Or you might decide you want to stick to the UK market, or invest in what are known as emerging markets (e.g. China and India).

You might want to limit your investments to certain sectors like technology or healthcare. Perhaps an ethical approach to investment is important to you, and you want an index that excludes things like fossil fuels or tobacco?

You might decide you want something a bit less risky or volatile by combining stock market investments and bonds in the same fund. 

Some tracker funds offer a fixed percentage in stocks and bonds and adjust their holdings automatically as prices move about (often called LifeStrategy funds). 

Other index trackers slowly reduce the amount you have invested in stocks as the years go by, in theory de-risking the fund as you get older (these are usually known as target date retirement funds).

Tracker funds are so cheap and flexible that you can invest in several of them if you prefer, and it’s easy to chop and change later on if you decide you want something a little different.

Most people seem to start with either a global index tracker or a global LifeStrategy fund, and then perhaps branch out further into more specialised tracker funds once they get more comfortable with how they work.

Once you have decided what you want to invest in, you can then draw up a shortlist of tracker funds that fall into this category. Many investment platforms have tools to help you do this.

Often you will find that there several different indices that will track the same thing. For example, there are a number from the likes of index providers such as MSCI, S&P, and FTSE that track world markets.

Cost is the main factor that many people use to decide between a group of index trackers. As a general rule, the fewer companies in a particular index, the lower cost the tracker fund will be. So sometimes you need to trade off between the depth of coverage and cost.

Each fund will publish an Ongoing Charge Figure (OCF), which is the annual percentage running cost. An OCF of 0.25% translates into £2.50 for every £1,000 you have invested. This cost is deducted automatically from the price of a fund so you don’t need to pay it directly yourself. However, the investment platform you use will also levy its own admin charge for holding the fund on your behalf, and this normally does require a direct payment.

Other factors to consider are how long a tracker fund has been in existence, how much in assets it manages, and how closely it has followed its chosen index over time (called tracking error in investing jargon). This information is normally set out in a fund’s factsheet, which should be updated monthly.

Older and larger funds are normally considered to be marginally safer as are trackers from the best-known index tracking firms like Vanguard, Fidelity, iShares, Legal & General, and HSBC.

Special considerations

If you’re interested in buying an open-ended tracker fund, you might find that there are a few different versions of the same fund. 

For example, a tracker fund may offer different unit classes (often referred to by a single letter like A, B, R, and T, although the specific letters usually don’t have any particular meaning). 

Depending on whether you buy a tracker fund directly from the company that runs it or from an investment platform, you might be offered a different class of unit. That’s important, as each class has a different cost even though they all own the same underlying investments.

Typically, index trackers bought via an investing platform will tend to be the cheapest classes. Once again, the fund’s monthly factsheet should outline the different classes available and how the costs differ. Sometimes different classes are used to offer the fund in different currencies like euros or dollars.

Not all funds offer different classes in this way, but if you see a single letter after a fund’s name then this usually means there are different types of unit classes available.

Another quirk of open-ended funds is that they usually offer income or accumulation units. 

As the names suggest, income units pay out dividends, usually quarterly, semi-annually, or annually, from the underlying investments held. Accumulation units keep this money within the fund and automatically reinvest it for you.

Note that accumulation units are deemed to pay a notional dividend, which is taxable in the same way as an actual dividend from an income unit. This can all get a bit messy but, thankfully, there’s an easy way to avoid this problem entirely.

If you hold your index trackers in an Individual Savings Account (ISA) or Self-Invested Personal Pension (SIPP) then you don’t have to pay income tax on any dividends (notional or otherwise) or capital gains tax on any profits.

What’s more, investing in a Stocks and Shares ISA usually doesn’t cost any additional money, giving you this tax protection for free. SIPPs are a little more complex, though, and will normally result in some additional charges.   

Examples of tracker funds

There are thousands of tracker funds to choose from but once you have decided exactly what you want to track, you can probably narrow the field to a dozen or fewer.

For global markets, the Vanguard All-World ETF, which was launched in 2012, is a popular option. Another is Fidelity Index World.

If you’re just interested in UK markets, then HSBC FTSE All Share Index and L&G UK Equity ETF are good examples.

If you’re after a mixture of stocks and bonds, Vanguard Lifestrategy funds appear to be the most popular option. They come in 20, 40, 60, 80, and 100 versions with the number signifying the percentage of the fund invested in the stock market.

FAQ

What is an index tracker?

An index tracker is a type of investment fund that automatically tracks a group of investments, following their price movements both up and down over time.

What are the best index tracker funds?

With tracker funds, the general rule is the lower the cost the better. Some indices are more complicated to track than others, so the costs for these will tend to be a little higher. But it’s a very competitive market, so there doesn’t tend to be a big difference between the lowest and highest cost tracker funds.

How does an index tracker work?

An index tracker allows you to follow the fortunes of a specific type of investment. A tracker fund will hold the investments specified in a particular index (like the FTSE 100 in the case of the UK stock market) and buy and sell the underlying investments while you pay a very low fee.

Do index tracker funds pay dividends?

Yes, index trackers do pay dividends. Some pay them out directly (income units) while others automatically reinvest these dividends on your behalf (accumulation units).