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How index trackers work

Index trackers are the investment vehicle of choice for ordinary Joe investors. Why? Because index trackers provide a low cost way to build a diversified portfolio that will outperform the average active investor.

Index trackers come highly recommended by some of the biggest names in investing.

Yale’s famed endowment fund manager, David Swenson, neatly summed up the advantages of trackers:

“With all assets, I recommend that people invest in index funds because they’re transparent, understandable, and low cost.”

Safety in numbers

Like other funds, tracker funds enable lots of investors to club together to increase their buying power.

They collectively buy shares or other assets across many more companies than any individual could

For example, trackers make it possible to invest in all the world’s stock markets via just one global index fund.

Index trackers can reduce risk and cost

Trackers are therefore a good way for everyday investors to get into the stock market without exposing themselves to the dangers of individual stock-picking.

Risks and costs are reduced thanks to the scale and diversity of the fund.

And while you’ll never beat the market’s performance with a tracker, you won’t lag it by much, either.

Indexes in (just a little) detail

Most funds have an aim. The aim of a tracker fund is to reproduce the returns of a specific market index.

An index is a basket of securities (such as shares or bonds) that is used to represent a particular segment of the market.

Famous indices that you’ll know from the Ten O’ Clock News include the:

  • FTSE 100
  • Dow Jones Industrial Average
  • Nikkei 225

An index is a bit like the financial equivalent of a poll. The body behind some particular index regularly surveys a sample of the market to get a snapshot of the bigger picture.

There are many weird and wonderful indices out there, from the All-Peru index to the Volatility Arbitrage index.

But virtually all of us only need to concern ourselves with the biggest ones around.

You need to know:

  • The market you want to track (e.g. UK domestic equity).
  • Which indices track that market, and how the indices differ.

You can then make an informed choice about which tracker to go for.

For example, UK equity is covered by a number of indices, the two most popular being the FTSE 100 and the FTSE All-Share.

  • The FTSE 100 tracks the 100 largest listed UK firms, and covers roughly 81% of the market1.
  • The FTSE All-Share covers 98% of the market; it bundles together the FTSE 100, FTSE 250 and FTSE Small Cap indices.

So if you want the most diversified index, you’d pick the All-Share.

If you only cared about Britain’s biggest companies, you’d pick the FTSE 100.

You can find out which index a tracker mimics by reading its fund factsheet.

For more about the indices, visit major providers like FTSE and MSCI.

Gain with less pain

A tracker’s job is to deliver the return of its index.

It usually does this by holding stocks (or other assets) in proportion to their presence in the index.

Some trackers will hold the lot, some only a sample, and yet others will replicate index returns using complicated swap deals2.

The key point is that trackers don’t try to pick the winners. They don’t market time. They just plod along tracking the index, handing over the returns due from the performance of its component securities.

By its very nature, a tracker will never hit three cherries on the fruit machine. It will never turn in a stellar index-trouncing result.

Its task is just to replicate the index.

In fact, a tracker will usually undershoot its benchmark due to fund costs.

But a tracker’s limited ambition makes it cheap to run – and it’s because they are cheap that most index trackers outperform more expensive active funds over the long term.

Types of trackers

There are two main types of tracker funds:

  • Index funds – Index funds are the simplest tracker type available, and the most suitable for small investors contributing monthly sums. The majority of these are now structured as Open Ended Investment Companies (OEIC), while a few are unit trusts. The US equivalent is called a mutual fund.
  • Exchange Traded Funds (ETFs) – These are basically index funds wrapped up in a share that’s quoted on the stock market, which you buy and sell like any other share. Buying ETFs therefore incurs trading costs that ramp up the expenses for small investors. There is though a far greater choice of ETFs than index funds – an ETF may be the only way you can get exposure to some markets.

There is a third type known as an investment trust tracker. These are few and far between and are generally pricier than index funds or ETFs, so aren’t worth worrying about3.

You can read more about the different types of tracker.

Take it steady,

The Accumulator

  1. In terms of the total market capitalisation []
  2. These differences in methodology are one reason for differing ‘tracking error’, which is the percentage amount by which a tracker fails to accurately track its index in any particular year []
  3. Some investors keep close tabs on investment trust trackers to see when their value deviates from their underlying value, but that’s not really what passive investing is all about! []

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{ 21 comments… add one }
  • 1 oldie November 17, 2015, 2:59 pm

    Hi

    Some ETFs are domiciled outside the UK and are not covered by the UK’s FSCS. Are they covered by other equivalent arrangements?
    Exactly what risks are being are involved?

    Thanks.

  • 2 The Investor November 17, 2015, 3:17 pm

    @Oldie — It’s a thorny issue. See this article: http://monevator.com/investor-compensation-scheme/

  • 3 magneto November 17, 2015, 5:00 pm

    Most investors assume that Vanguard is totally safe for a one stop global fund. Am inclined to this view also, that if anyone is trustworthy then it is Vanguard. But can we say “totally”?
    Have been adding to VWRL lately and pencilled in to add more.
    However re-watching ‘Inside Job’ the other day and it occurs that where huge amounts of money and frail humans (esp men), are involved things sometimes do go most unexpectedly wrong, and others suffer.
    Am not saying that Vanguard will go off the rails (most unlikely due to structure), but usually when depositing our money we take care to diversify (eggs and baskets).
    So maybe will continue to spread funds among managers in the name of prudence.

  • 4 The Rhino November 17, 2015, 5:43 pm

    @magneto – i have worries in exactly this area – I really want a few more competitive life strategy type funds to appear in the market so i can diversify away from vanguard.

  • 5 polpo November 17, 2015, 7:22 pm

    @magneto – me too. I make a allocation to 1) Vanguard All World ETF and 2) iShares MSCI World plus iShares Emerging Markets (iShares World is being developed market only). 90%/10% in the case of (2)

    Risk of a Vanguard melt down seem remote but one would feel a real twit if something went wrong – c/f monevator advice about ‘assuming every investment can fail you’

  • 6 Mr and Mrs Geek November 18, 2015, 1:38 pm

    Hi guys,
    From my understanding all the fund management institutions (i.e. Vanguard) are mandated to use a trustee where the trustee is the company that holds the fund’s underlying assets in trust. So even Vanguard or your broker vanishes the trustee is still there. But please correct if I’m wrong!

    For alternative options to Vanguard Lifestrategy take a look at Blackrock Consensus or L&G Multi Index or HSBC World Index Portfolios but all of them are more expensive then Vanguard 😐

  • 7 Jonny November 18, 2015, 2:10 pm

    @magneto, @the rhine, @polpo

    You can add me to the list of worriers too!

    I’d say I’m stuck in analysis paralysis mode, but the honest truth is I can’t bear to start the pre-research mode (i.e. investigation suitable, simple, straightforward alternatives) at the moment, let alone analysing what I find. In fact it’s been on “this weeks” to-do list since April!

  • 8 2lazy November 18, 2015, 7:33 pm
  • 9 Mike November 18, 2015, 8:30 pm

    You say that investment trust trackers are pricier and not worth worrying about, but if you can buy say AUKT (which has OCF 0.32%) at a 5% discount (which is the 12m month average discount per hl.co.uk) wouldn’t that be worth considering?

  • 10 David November 19, 2015, 9:20 am

    I couldn’t bring myself to invest in indices but your articles are so convincing that I will definitely do that someday 🙂

  • 11 The Investor November 19, 2015, 10:04 am

    @Mike — I’m not the author (that’s my co-blogger The Accumulator) but I’d say while it *might* be worth considering if you’re an investing nerd (like me! 🙂 ) what’s the point for the average passive investor? They are not likely to monitor the discount closing, so won’t benefit from any modest re-rating there, and at the same time they expose themselves to the extra *risk* of the discount widening, reducing the value of their holdings, especially at a time of instability in the market like 2008-2009, due to the closed-end nature of the fund.

    Extra risk for negligible/uncertain extra reward that doesn’t fit into an investing strategy isn’t really part of the passive investing playbook.

    You can track the UK All-Share via a Vanguard tracker with an OCF of just 0.08% or if you want similar instant liquidity to AUKT it has a FTSE 100 tracking ETF with an OCF of 0.09%. (Source: Vanguard), which makes that 0.32% OCF for AUKT look positively outrageous. 😉

  • 12 oldie November 19, 2015, 10:37 am

    Am I right in thinking that IT’s are sometimes considered as a way of not having to pay the platform charges that go with UT/OEIC trackers ?

  • 13 The Rhino November 19, 2015, 11:00 am

    @oldie you are right that ITs don’t tend to attract platform charges, but neither do ETFs.

  • 14 The Accumulator November 19, 2015, 5:52 pm

    Depends on platform, but they do attract stamp duty and dealing fees

  • 15 Mike November 19, 2015, 8:55 pm

    Thanks TI. That’s certainly one way of looking at re profiting from the discount reversing. However that wasn’t my thinking when I bought AUKT. If you buy say £950 of AUKT with a 5% disccount then you’ll get £1000 of underlying assets. Now with a 0.32% OCF the manager will take £3.2 per year from the income the fund produces. But there’s also £50 worth of assets that are producing dividends in the fund that you get essentially for free. Let’s assume a 3.5% dividend yield for all-share then the £50 will produce £1.75 per year. So now the charge is £1.45 (£3.2 less £1.75) which is c0.15%. If you plan on holding for say 20 years then the discount widening shouldn’t be a problem – plus there’s the upside of the discount narrowing so can sell and move to a cheaper fund.

    But do agree that Vanguard is a better bet and cheaper. I was trying to move some funds away from Vanguard as I realised that I was starting to accumulate too much with one company. Plus while ETFs are great there’s something I find unsettling about them being Irish domiciled (especially if we come out the EU) so don’t want a too much tied up with them.

    Mike

  • 16 Ewan November 21, 2015, 4:10 pm

    Hello, I’m a long time reader, first time commentator. First of all, thanks for the blog!

    I was wondering if anyone knows how tracker funds, like the Vanguard ones, decide to vote – e.g. at an EGM to approve a merger? Do they even vote? Does this have implications on quorums? Are non-votes ever counted to take some default value (so turn out is always 100%)?

    FYI I’m not asking for any specific reason – I just got curious after reading about the Willis / Towers Watson merger where there were some significant Towers’ shareholders urging others to decline the (first) proposal and I’m don’t know how Vanguard (or similar) would respond in this situation.

  • 17 The rhino November 22, 2015, 12:16 pm

    Why is it that the finance industry habitually charges as a % of assets under management when even the utter charlatans that represent the letting agencies only charge a % of the income? It makes no sense.

  • 18 Ewan November 22, 2015, 4:46 pm

    @The rhino: I’m not speaking with any authority but…

    Expressing charges as a % of assets under management is convenient for calculations and comparisons, so regardless of how the charges are calculated, it would make sense to express them as a %.

    I’m not convinced that charges are calculated as a % of assets under management. I would guess that competition in the fund market is high enough so that charges are fair.

    More widely, it’s not the case that all brokers charge a % of assets held, there are fixed fee brokers.

  • 19 The rhino November 22, 2015, 7:58 pm

    @ewan I think we’re at cross purposes here.

    My point is even letting agents who can and will charge for everything under the sun still wouldn’t try taking a % of the value of the property as their fee. Whereas this is exactly what every fund, etf and IT does (I’m not talking about the brokers though some of them have a go at it too).

    Is it just a quirk of fate that this has become defacto acceptable way of charging people. It just seems like a bad deal for the people. All upside no downside for the fund manager.

    It’s crazy. Totally crazy. No punter in their right mind should accept such terms yet they are absolutely standard across the industry

  • 20 Ewan November 22, 2015, 9:10 pm

    But the way in which they present their charges (i.e. % of fund value) is not necessarily how they determine what the charges are.

    The funds incur expenses and the investors need to pay for them. The % charge will be based with the knowledge of what the $ cost is and what the fund value is.

    It’s only a bad deal (on average) if the overall expense charge for the fund is higher than what the fund manger would be willing to accept. e.g. if a fund grew in value faster than their expenses and they didn’t reduce the % charge.

    However, funds do reduce their % charges (e.g. Vanguard did in August 2014) so I don’t buy it that the charge is determined as a % of fund value, even though they are always expressed as a % of fund value.

    But no matter how the charges are determined, if there is strong competition between fund providers then the charge will be ‘fair’ for the total fund.

    There is downside for the fund manager – if they set the % charge based on expected fund value and the fund doesn’t meet expectations then their actual income will be lower than expected.

    There is another argument about how the total fund charge should be distributed among investors. i.e. by % of value. The fairness of this expense allocation is a different issue to the fairness of the overall expense charge. Any allocation system will be benefit some members more than others, but it can still be a good deal for everyone – as long as everyone covers their own variable costs.

  • 21 The rhino November 22, 2015, 9:41 pm

    Hmm maybe, maybe not

    I think a tiny vanguard like fee of 0.09% for a tracker is prob fair do s

    However any active fund should really only charge a % of income and growth achieved. A bit like what the tax man does. No income, no growth then no fee.

    Or even better. Lets bring back some buffet style fees!

    https://www.scmessina.com/2015/03/what-was-the-fee-structure-of-warren-buffetts-first-investment-partnership-started-in-1956/

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