How to choose the best index trackers #1: Basics

There now follows a whistle-stop tour of the features to look out for when choosing the best index trackers for your portfolio ^[12].

I use this rundown as a quick checklist to help me navigate the investing minefield without being reduced to bloody stumps. Even in the relatively benign terrain of passive investing ^[13], you can too easily choose a wealth-damaging product if you don’t tread carefully.

Note: I use the term index tracker here to refer to BOTH index funds and Exchange Traded Funds (ETFs).

I’ve split the checklist into four parts (watch out for parts two – four over the next few weeks), as it would be a lot to digest in one helping. Once you’ve bought your first fund or two, you should be able to skim through the checklist at speed, just using the big blue sub-heads to keep you on track.

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First, choose your asset class ^[15]

Each index tracker focuses on a specific part of the investable market. Do you want to hold equities or bonds, property or commodities?

You can keep things simple with total market type funds that hold a broad mix of an entire asset class. iShares MSCI World ETF, for example, represents the entire developed world equity market in one fund.

Alternatively, you can select exposure to subsets of each asset class.

• Most equity funds diversify by geography and size.

• Bond funds mostly diversify by geography, quality, duration and anti-inflation (or not!) characteristics.

Select the right index

Knowing which index your potential fund tracks ^[16] is as important as knowing which route you’re going to take to work. You can’t get to where you’re going without that underlying understanding.

Google the index to find out:

• Which asset class it covers.

• How representative of the market is it? E.g. The FTSE All-Share covers around 98% of the UK investable market while the FTSE 100 accounts for less, about 81%.

• Is the index concentrated in particular sectors, companies, or countries?

• Is it liquid? Trading costs rise for stodgy indices.

• What are the index rebalancing rules? The more companies drop in and out, the higher the turnover costs (see checklist part two).

• Is it subject to any special rules? Most indexes are market cap-weighted, but some are price-weighted or select firms by certain fundamental measures.

• Which version of the index are you tracking? An accumulating fund should track a total return index. An income fund should be compared with a price return index.

• Do the index holdings overlap significantly with others in your portfolio?

Fund structure

Index trackers breakdown into index funds and Exchange Traded Funds (ETFs) ^[17].

Index funds are simpler to use and have a longer track record of doing a job for passive investors ^[18]. ETFs are innovative, more flexible, are multiplying like devil spawn and require a deeper understanding to use without hazard.

Index funds sub-divide into:

• Unit Trusts
• Open-Ended Investment Companies (OEICs)

The practical difference between those two structures is negligible for passive investors.

ETFs are part of the wider Exchange Traded Product (ETP) family that includes:

• Exchange Traded Commodities/Currencies (ETCs) – track oil, gold, cattle, renminbi etc.
• Exchange Traded Notes (ETNs) – a debt instrument for tracking hard-to-reach indices. Avoid unless you know what you’re doing.
• Certificates – Essentially the same as ETNs.

For completion sake, there are also one or two investment trust trackers on the market. They’re only worth a look if you understand the complexities of trading ITs at premiums and discounts ^[19].

Replication strategy

How does a tracker mimic its index? In order of preference choose from:

• Full physical replication – The fund holds every security in the same proportion as the index.

• Sampling/Optimised – The fund holds a representative cross-section of the index because it’s too expensive to hold every security. Replication is physical, but tracking error is likely to be higher in comparison to full replication.

• Synthetic – So-called synthetic ETFs ^[20] use derivatives known as total return swaps to earn the return of an index, without having to hold any of its component securities. Swaps are good for tracking error but they expose you to counterparty and collateral risk.

That wraps up the basic criteria I think about when choosing the best index trackers out there. Part two of this checklist looks at costs ^[5], part three exposes some of the lesser publicised ^[6] tracker wrinkles you need to know about, and part four looks at ETF-only quirks ^[7].

Take it steady,

The Accumulator

Series Navigation

Picking an index tracker out of the investing swamp ^[4]How to choose the best index trackers #2: Costs ^[5]