Should you buy tracker funds instead of company shares?

This week saw the 40th anniversary of the first tracker fund. As a coincidence, this week was also the first time that Hargreaves Lansdown has included tracker funds in its Wealth 150 list since its launch in 2003.

Undoubtedly, tracker funds are becoming more popular. They offer a number of benefits over buying and selling individual company shares. A central benefit is their diversification. For example, the FTSE 100 tracker provides access to 100 different stocks and this makes a huge difference to smaller investors for whom it’s uneconomic to buy 20-30 individual stocks in order to reduce company-specific risk to an acceptable level.

Furthermore, tracker funds are simpler and far less time consuming than company shares. They don’t require the same extent of ongoing research, nor do they lack the income appeal of shares versus other asset classes at the present time. And with many tracker funds charging 0.3% or less, the cost of ownership could be less than the cost of buying and selling company shares over the long term.

In addition, tracker funds have performed well. Since the FTSE 100 was born in January 1984, it has recorded a total return of around 9% per annum. While no tracker fund will perfectly match the return of the index, and costs must be deducted, earning a return of 9% per year over a period of almost 33 years sounds like an excellent vehicle through which to grow your wealth in the long run.

As such, tracker funds have significantly more appeal compared to other assets such as cash, property and bonds. But owning company shares could be even better for most investors.

Superior return

That’s because a superior return compared to the index is very achievable by adopting a relatively small number of simple steps. For example, instead of buying a tracker fund, investors could focus on identifying the best quality companies based on their track records, competitive advantage versus peers and future forecasts. Then, by assessing their valuation based on metrics such as the price-to-earnings and price-to-book ratios, it’s possible to buy the better quality companies at the best prices.

In addition, investors in company shares are able to take advantage of short-term disappointments in order to make long-term gains. Sometimes the best moment to buy a stock is just after a major price fall when the market has become overly negative regarding its future prospects. Although value traps do exist, better value stocks have allowed investors such as Warren Buffett to beat the market.

In fact, had Warren Buffett invested in a tracker fund instead of in company shares, the reality is that he would be far less well off. Although he’s just one example, he’s nevertheless proof that a simple strategy when it comes to buying shares can be highly worthwhile and beat the performance of tracker funds. While they’re better than owning no stocks at all, buying companies directly still seems to be the best risk/reward opportunity for the long term.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK has recommended Hargreaves Lansdown. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.