- Monevator - http://monevator.com -

How index trackers work

Index trackers are the investment vehicle [1] of choice for ordinary Joe investors. Why? Because index trackers provide a low cost way to build a diversified portfolio that will outperform [2] the average active investor.

Index trackers come highly recommended [3] by some of the biggest names in investing.

Yale’s famed endowment fund [4] manager, David Swenson, neatly summed up the advantages [5] 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 [6].

Index trackers can reduce risk and cost [7]

Trackers [8] 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 [9].

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:

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:

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.

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 [11] and MSCI [12].

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 deals [13]2 [14].

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 [15] that most index trackers outperform [16] more expensive active funds over the long term.

Types of trackers

There are two main types of tracker funds:

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 [18], so aren’t worth worrying about3 [19].

You can read more about the different types of tracker [20].

Take it steady,

The Accumulator

  1. In terms of the total market capitalisation [ [23]]
  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 [ [24]]
  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! [ [25]]