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Why investing in index trackers might not be right for you

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The index tracker is 50 years old this month.

Globally, there’s apparently some US$16 trillion invested in them. They’re clearly right for plenty of investors. But are they right for you?

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Don’t get me wrong. I’m a big fan of index trackers. I invested in them for years. A FTSE All-Share tracker, of course. But also Asia-Pacific, European, and American S&P 500 trackers.

Even so, I don’t hold any now. And I haven’t for many years. Because for discerning investors, individual shares can prove to be a better bet.

And again, don’t get me wrong. I’ve encountered plenty of people for whom tracker investing is a core part of their investment strategy — even in retirement. It’s simply a question of circumstances, choice, and individuals’ risk appetite.

So… are index trackers right for you? Or could you get closer to your investment aspirations with individual shares? Let’s take a look at three arguments against index trackers.

1. An index tracker tracks the index

I know, I know. Put like that it sounds stupid, and obvious. But it’s still a worthwhile point.

Pick an index — the FTSE All-Share index, say, which is more broadly focused than the FTSE 100 index, dominated as the Footsie is by a clutch of resources shares, consumer-facing shares, and financials.

It goes down 1%, say. Or 5%, or 10% — or 50% or so, as can happen during market meltdowns.

And so too do the index trackers tracking the FTSE All-Share, and so too — obviously — does the value of your investment. Whatever the index does, so does the tracker.

Individual shares can be more resilient. Consumer-facing businesses, for instance, are usually more resilient, thanks to their defensive nature. Financials can also be more resilient, although that isn’t a hard-and-fast rule, as we saw back in 2007-2008.

If you don’t enjoy volatility, then defensive shares may be a better pick.

2. An index tracker mirrors the market

I know, I know. Once again, it seems obvious. But the implications are less so.

Take the FTSE 100. A hundred shares, you might think. Pretty diversified. Well, yes and no. Because an index tracker holds shares in proportion to their weighting in the index.

Down at the bottom of the FTSE 100, there are lots of companies with a market capitalisation of £5 billion or so. But up at the top of the FTSE 100, you’ll find companies over 20 times that size, with market capitalisations comfortably in excess of £100 billion.

The result? Buy a FTSE 100 index tracker, and just short of 40% of your wealth will be tied-up in just ten companies – the ten largest companies in the index. Buying a FTSE All-Share tracker dilutes that somewhat, but only somewhat. Those same ten companies will tie up just over 30% of your wealth.

I don’t know about you, but I prefer to be a little more diversified.

3. An index tracker is more for growth than income

Again, let’s use the familiar FTSE 100 as an example.

In it, there are plenty of companies that pay a decent dividend. But there are also plenty of companies that don’t — either because they’ve fallen on hard times, or because they are growth-led companies, aiming to reinvest profits in driving the business forward, rather than paying a generous dividend to shareholders.

Overall, the FTSE 100 yields 3.05% — better than you’ll get in the bank, to be sure, but a far cry from the 5–6% yields offered by the Footsie’s higher-yielding stocks.

Put another way, every £1,000 invested in the FTSE 100 will pay you an annual income of £30, rather than £50–60.

I know which I’d prefer, in retirement.

The bottom line

Trackers are big business. And these days, they offer good value, with tracker fees beaten down by fierce competition between providers.

But they’re still not for everyone.

Are they for you? Or would individual shares be better? Only you can decide.

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