Tracker funds

Tracker funds can be a low-cost investment option that is simple to understand and may offer attractive returns. Find out more...

Tracker funds are low-cost collective investment schemes that follow the movement of an index, rather than the price of individual shares.

Trackers are known as 'passive' investments because a fund manager doesn't make any 'active' decisions about markets or individual investments.

This means that tracker funds typically charge lower fees, a factor that can make a significant difference to investments.

This doesn't mean that they're necessarily less of a risk than a managed fund, nor that the potential returns are less.

A tracker fund may out-perform or under-perform a managed fund.

As with other sorts of investment you should remember that the value of your funds can go down as well as up, meaning that neither your returns nor your original investment are guaranteed.

What's an index?

An index is an imaginary portfolio of investments - for example the FTSE 100 index contains the 100 largest companies on the London Stock Exchange - and rising share prices will make the index go up while falling share prices make it drop.

Some of the shares in the index might be increasing in value while others are losing value - but the index gives an overall picture of the market, taking into account these ups and down.

How tracker funds work

Instead of investing in hand-picked companies and shares and hoping that your investment will beat the market and pay off, tracker funds instead aim to track the performance of the index itself, such as the FTSE 100.

Some trackers buy shares in all the companies that make up the index in proportion to the size of the companies within the index.

Others track the index by buying shares in a variety of companies that are representative of the whole index, aiming to get a realistic cross-section of the index.

Different types of tracker funds

There are two main types of tracker funds: synthetic trackers and fully replicated trackers.

Fully replicated trackers

Fully replicated trackers buy shares from all companies in the index, and pay dividends.

This is the more common and popular type of tracker fund, as they perform as closely to the index as possible.

Synthetic trackers

Synthetic trackers don't actually buy any shares - instead there's an agreement in place with a financial partner to pay the return on the selected index, in return for a stream of cash.

Some of these don't pay dividends, so it's important to read the small print. Check whether you're buying into a tracker fund that either pays out or reinvests dividends; your preference is likely to depend on what you want from your investment.

Advantages of tracker funds

There are a number of reasons why a tracker fund might be the right investment for you.

Cost

Tracker funds are a popular investment choice for beginners who are taking their first step away from traditional savings because they're a cost-effective way to invest.

Since tracker funds don't need a fund manager to decide shares, they usually charge lower fees than managed funds.

Reliability

Tracker funds are also considered a safer bet than many managed funds as they're not trying to outperform the market, merely match it.

You're not at the mercy of a fund manager's stock-picking prowess (or lack of it) so your investment should always generate returns roughly in line with the market.

Time and expertise

Tracker funds don't require a great deal of research and expertise to invest, so they may be more suitable for novice investors who don't want to spend time picking their investments.

Disadvantages of tracker funds

Tracking error

Tracker funds can make mistakes when tracking the index and fail to replicate the index accurately. This can be a small error, but will still make a difference.

Because of this, think about looking for tracker funds with lower tracking errors.

Disproportionate investment

As tracker funds are linked to the index their value reflects the value of that index, which may be disproportionately affected by larger companies who take up a large proportion of the index.

This means you may be effectively investing heavily in one company or industry, and your investment may suffer if it underperforms.

Fees

Although tracker funds tend to be a lower-fee way to invest, you should still shop around and compare fees before choosing your investment.

Be aware that there may be charges for buying and selling the funds, which could eat into your returns.

If you're attracted to tracker funds based on their lower fees, make sure you check the fees of your funds of choice beforehand.

How to invest in tracker funds

To invest in tracker funds, you could find the right one for you through an investment supermarket or you could buy directly from a fund management firm.

You might also find that some online investment management services invest either partially or wholly in tracker funds.

While an investment supermarket and online investment management services will charge fees, going direct to a fund management firm is usually much more expensive.

You can put tracker funds within a tax-free Individual Savings Account (Isa) wrapper, so make the most of your Stocks and Shares Isa allowance.

Always remember that if you don't understand an investment you probably shouldn't commit to it, so if you're unsure read more on how to go about finding the right financial guidance and advice.

By Emily Bater

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Closet trackers: Appendix

Alongside 'active' and 'passive' fund management, there's a third, controversial way of handling assets that's known as closet tracking; you may also see such a fund referred to as a 'quasi-tracker', or the practice referred to as 'index-hugging'.

This is where an investor pays a fund manager to actively manage their assets, but in reality all that the fund manager does is to track an index; a service that the investor is likely to have been able to get through a tracker fund for a much smaller fee.

It has been suggested that this could be another financial scandal to rival the mis-selling of PPI (payment protection insurance).

Research by the European Securities and Markets Authority has estimated that 5-15% of all European regulated funds could be closet trackers, while fund research group Morningstar has suggested that the figure may be as high as 20%.

In March 2016 this practice was being investigated in Germany, Sweden, Ireland and Luxembourg. In the UK the Financial Conduct Authority was looking at it as part of a wider investigation into asset management, whilst in Norway consumers have begun a class action against financial services group DNB over the running of a tracker fund.

"What we're doing is to ensure the ethics within the financial services industry is good enough when it comes to how they're selling funds," Georg Jensen of the Norwegian Consumer Council told the BBC's Money Box programme in March 2016.^†

"We're also raising awareness with consumers that they should look out for the promises that the sellers of funds are giving them, and that they may not be the truth."

Gervais Williams, an active fund manager at the London-based Miton Group, suggested that any problems with index-hugging should not be applied to all sectors of the asset management industry.

"In the retail fund management industry it's not a very big issue because we're here to make money for our clients and it's a very competitive industry," he told the BBC.

"If you're just sticking with the index in, say, the equity income sector, the market may be up 10% in three years but the average equity income fund is up about 22.7%.

"If you stuck by the index you wouldn't make any money for your clients and you wouldn't have any clients... the retail fund management industry is all about delivering premium returns.

"With active management there should be times when you're far away from the index, but there may be times when it's right to be in the herd because risk can be very substantial.

"You don't need to be taking outlandish risks with your clients' money at times when things are very uncertain, so there are times when you might want to move back to a more conventional set of holdings that's closer to the index.

"That doesn't mean the fund's not actively managed... it means that risk has been moved back to a more average level in the hope of minimising loss for clients. Those active fund managers should then move back away from indices when opportunities are better."

How do I spot a closet tracker?

Closet trackers can be reasonably easy to spot, and the first step is to compare the holdings levels to those of an index; the top four holdings should give a good indication, but it would be better to look at the top 10 or, preferably, all holdings.

You should also look at how tracking errors compare with that of the index, preferably over an extended period, perhaps three-to-five-years.

In a consideration of the FTSE 100 index, Christopher Traulsen of Morningstar told the BBC: "An active fund manager might hold nothing in the top holdings of the index, companies like BP or HSBC... if you remember all the controversy there was around BP a few years ago, as an active fund manager you'd have a big decision to make there.

"But if you're a closet tracker manager you're more thinking, 'I don't like that stock very much, but I need to hold it to keep my tracking error in line with the index'.

"A true tracker would hold every single stock in the exact same percentage - or as close as they can manage - to what the index holds. If it's an active fund, no, it's your decision as a fund manager and you may manage it without reference to the index at all."

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