What are index-tracking funds?
Index-tracking funds (trackers) are investment funds that aim to match the performance of a particular investment index (e.g. the FTSE 100). Unlike actively managed funds, there is no highly paid fund manager
making investment decisions, they can more or less be run by computer to replicate the index they're tracking. As a result, charges tend to be far lower than actively
What's an index?
Indices are calculated by financial companies to measure the performance of stock markets and most other asset types. They provide a simple 'at a glance' indication of
how a particular market or asset is performing. In the UK the FTSE 100 is probably the best known index, this measures the performance of the 100 largest companies on the
London Stock Exchange.
Some indices (particularly those measuring stock markets) are weighted. This means means that a company's weight in the index is based on either their share price
(price weighting) or size (market weighting). Under a market weighted index a large company will therefore have more influence on the index than a smaller one. In an
unweighted index all items (e.g. companies) make up an equal share.
When tracking weighted indices such as the FTSE 100 or AllShare bear in mind that your money will not be spread as widely as you might think. For example, when you buy
a FTSE 100 tracker your money is not split equally between 100 companies, but split in proportion to their size. Because the FTSE 100 is dominated by some very large
companies you'll find around half (i.e. 50%) your investment dependent upon the performance of the 10 largest companies. Surprisingly, this figure only falls to around 40%
for the FTSE AllShare Index, which comprises around 800 companies.
A side-effect of this is that a weighted index, hence your tracker, will be biased towards certain sectors. For example, the oil & gas and financials sectors (combined)
typically comprise nearly half the FTSE 100 Index.
This is not a reason to avoid trackers, but do pay attention to how dependent yours investments may be on particular companies and sectors.
What's in an index?
When investing in an index you should appreciate what's in it. Firstly, understand what type of asset is held, e.g. stockmarket shares or commodities etc. Secondly,
check the extent that an index invests in certain areas, especially important with weighted indices - if you're not careful you could end up investing a lot more in
certain areas that you might think.
The charts below show the extent that popular indices covering the UK and Chinese stockmarkets invest in certain sectors (data sourced from
ishares, last updated 29/02/12).
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The simple answer is that in many markets trackers typically perform better than actively managed funds, due to a combination of lower charges and the fact many active
fund managers are seemingly poor at their job and/or unwilling to take sufficient risks to beat the index.
The figures below cover a range of unit trust sectors, showing the percentage of actively managed funds that have beaten their associated index over the last five
Are active managers any better than monkeys?
Suppose we let 1,000 monkeys run their own investment funds, with them picking shares from a hat (i.e. the funds are run randomly), how well would we expect them to
Well, assuming no charges, we'd expect 500 to beat the index and 500 to underperform the index in any given year. We would also expect 500 to beat the index cumulatively
(i.e. in total) over five years but just 31 to beat the index every year for five years.
If our monkeys start charging total annual fees of 1.6% (typical for unit trusts), then we'd expect 429 to beat the index in any year, 345 to beat it cumulatively over
five years and only 14 to beat it every year for five years (assuming an annual standard deviation (i.e. volatility) of 9%).
How does this compare with what happens in the real world?
|Monkeys versus Active Fund Managers
||% beating FTSE All Share Index (figures to 05/11/10)
|Over the last year
||Over the last 5 years
||In each of the last 5 years
|Monkey figures intended to show probability assuming random stock selection with an annual standard deviation of 9% and total
annual charges of 1.6%. Active manager figures based on actively managed funds from the IMA UK All Companies Sector.
So, based on these figures, the only major differences between monkeys and typical fund managers seem to be a fat salary and pinstripe suit! You should take this with a
pinch of salt, after all, some fund managers have proven themselves to be exceptionally good over many years. But these figures highlight the difficulty of finding good managers
and are a great advert for buying low cost tracking funds, for exposure to the mainstream UK stockmarket at least.
What's the best way to measure how good an active manager is?
Simply looking at his or her performance is not very useful. As a bare minimum we need to compare it to a suitable benchmark, i.e. an index that represents the
market(s)/asset(s) in which the manager invests. This tells us whether you might have done better by investing in a tracker.
However, the manager might have beaten the index over, say, five years thanks to one very lucky year. Much better to look at each year in turn, i.e. 'discrete performance'
This gives a good indication of how consistent a manager is and whether their overall performance has been helped by some 'freak' periods.
What would be really useful is finding a figure that measures how well a manager has performed against their benchmark relative to the risk they have taken.
An 'information ratio' does just this. It's calculated by dividing the manager's return relative to the benchmark (known as 'excess return') by the standard deviation of
the difference between the fund and index returns (known as 'tracking error').
Information Ratio = Excess Return / Tracking Error.
The benchmark for all three managers is Index Z which returns 6%.
Manager A returns 10% with a tracking error of 3%. Information ratio = (10% - 6%) / 3% = 1.33%
Manager B returns 12% with a tracking error of 6%. Information ratio = (12% - 6%) / 5% = 1%
Manager C returns 5% with a tracking error of 2%. Information ratio = (5% - 6%) / 2% = -0.5%
Although manager B delivered the highest return, manager A delivered a more attractive return relative to the risk taken. Manager C actually destroyed value by takin more
risk than the index but returning less.
A high information ratio means a manager is delivering attractive returns relative to the risks they've taken, attractive for investors.
Why do active managers struggle to beat the index?
In large developed markets, such as the US and UK, most large and medium companies are very well researched (i.e. they're efficient markets) so it's hard for a manager to gain an edge through spotting
opportunities that others have missed. To improve their chances of success a manager will therefore have to take big sector and/or company size positions versus the index (e.g.
they might choose to have a lot less financial company exposure than the index). The problem is some managers are not keen to take such risks, while others do and get it
wrong. Add in the high annual charges of active management and it becomes even more difficult for a manager to beat the index.
When don't trackers work?
In theory active managers are likely to have greater success in smaller, less efficient, markets such as smaller companies and developing economies, so the argument for trackers in these
markets is less clear cut. While this just about seems to hold true for smaller companies, many emerging markets active managers do underperform so the case for active
management here is less convincing.
There are also some assets where trying to construct a fund that tracks an index is impractical, e.g. property. The IPD UK All Property Index is calculated using
over 3,500 commercial properties. It simply wouldn't be possible for a commercial property tracker fund to own this many properties, if any at all. That's why we've yet
to see a meaningful physical property tracker fund (they are in theory possible using complex financial derivatives offered by investment banks, but these have their own
set of risks). There are some property trackers that track property company shares, but these have a higher correlation to stock markets than physical property.
Since a key advantage of tracker funds is their low charges, the few on the market with high charges don't make sense and are best avoided.
What types are there?
Unit TrustsInvestment TrustsETFsPension Funds
Stock market tracking unit trusts are plentiful and usually fairly cheap. The majority focus on the FTSE 100 and FTSE All Share, although there is enough choice to get
reasonable overseas stock market exposure too. Never pay an initial charge and beware annual charges over 0.5% (for UK trackers at least) as you'll probably be paying
over the odds.
Unit trusts are usually the most cost effective option if you want to hold a tracker within an Individual Savings Account (ISA), as most unit trust managers provide the
ISA wrapper free of charge.
How much do they cost?
Trackers should be cheap. That means no initial charge and total annual charges of 0.5% or less, although some specialist trackers may charge up to 1% per annum.
The cost savings from using a low cost tracker versus an actively managed fund can be astounding, potentially running into thousands of pounds over a number of years.
Fund A is actively managed and charges 5% initially followed by total annual charges of 1.6%.
Fund B is a tracker with no initial charge and total annual charges of 0.3%.
Assuming a 6% annual return (before charges), then after 20 years a £10,000 investment would be worth:
Fund A: £22,477 Fund B: £30,304
i.e. Fund A has effectively cost an extra £7,827
Of course, you shouldn't just focus on cost. A good active manager could more than outweigh their charges, proving excellent value for money. Nonetheless, because
many active managers fail to do this then cost can have a major influence on how well your investments perform over time.
Should I use trackers?
Despite the huge amount of resource that some investment companies and advisers pile into researching actively managed funds, the bottom line is that they, along with the rest of us, end up
making an educated guess on whether a particular fund might perform better than a tracker. While some appear to be better at guessing than others, everyone gets it wrong at
times (I know I have!). So, for certain types of investment, trackers arguably make more sense than actively managed funds. Why pay high charges and run a real risk of
underperforming a tracker?
Having said this, trackers tend to work better in some investment areas than others, so you may well be better off combining both trackers and actively managed funds
in your portfolio, i.e. let them each play to their strengths.
The table below shows where trackers do and don't tend to work.
|Trackers vs Actively Managed Funds
|Investment areas that tend to favour
||Actively Managed Funds
- Stockmarkets (large and medium sized companies)
- Investment grade corporate bonds
- Property (property shares)
- Stockmarkets (smaller companies & those not covered by trackers)
- High yield corporate bonds
- Property (physical property)
- Absolute return funds
|Commodities (Hard & Soft): While trackers provide a much wider choice for commodities exposure (via ETFs) than actively managed funds,
they can suffer from underperformance where it's not practical for the tracker to own the underlying commodity, e.g. oil and most soft commodities such as corn and sugar. This is because the
trackers must instead use monthly futures contracts to track the commodity price and certain costs can hurt performance (called 'contango') - see our commodities
page for more details.|
How can I buy trackers?
You can buy tracker unit trusts either directly from fund providers or via investment advisers and brokers. Commission based investment advisers are not generally keen
on trackers because they pay little, if any, commission.
You can buy ETFs and investment trusts through stockbrokers. Dealing by telephone or online is usually the cheapest option, where you can expect to pay around £6 - £15
There are thousands of indices worldwide, covering a multitude of investment types. However, some tend to be far more popular than others when it comes to tracking.
|Popular Indices used by Trackers
||UK stock market (large companies)
||UK stock market (medium to large companies)
|FTSE All Share
||UK stock market (all companies)
||US stock market (large companies)
|Dow Jones EuroSTOXX 50
||European stock markets (large companies)
||Japanese stock market (large companies)
||Developed world stock markets (large companies)
|FTSE UK All Stocks Gilt
||UK gilts (all gilts)
||UK corporate bonds (investment grade)
|Dow Jones AIGCI
||Commodities (hard and soft)
||Liquidity & Production
The world of trackers is full of jargon. Here's some of the more common terms you might come across:
|ETF||Exchange Traded Fund, a type of invesment fund traded on the stock market that's ideally suited to tracking indices.
|Index||A statistic calculated by financial companies to measure the performance of stock markets and most other asset types, e.g. FTSE 100.
|Information Ratio||A statistic that measures how well an investment manager has performed against their benchmark relative to the risk they have taken.
|Tracker Fund||An investment fund that tries to replicate a specific index rather than being run by an active fund manager.
|Tracking Error||A statistic that measures how accurately a tracker fund tracks an index. It's the standard deviation of the difference between the fund and index returns.
|Weighted Index||An investment index where a company's weighting is based on either their share price (price weighting) or size (market weighting).