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. Independent Financial Advisers are less keen on them though, because trackers don’t pay out juicy commissions.

Yale’s famed endowment fund manager, David Swenson, neatly sums 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. Tracker funds collectively buy shares or other assets across many more companies than any individual could (Warren Buffet aside).

Trackers are a good way for small 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 to the Volatility Arbitrage index.

You need to know:

• What 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 to be the index.

In fact, a tracker will usually undershoot its benchmark due to fund costs. But it’s a tracker’s limited ambition that 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.

I’ll tackle the differences between the tracker types in detail in a future piece.

Take it steady,

The Accumulator

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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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