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Your step-by-step guide to tracker funds

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Tracker funds are said to be one of the cheapest ways to invest in the stock market. We look at how they work.

Put simply, tracker funds are based on the notion that it is very hard to beat the market so why bother trying?

This guide is designed to help you understand the advantages of tracker funds and how to use them.

What are tracker funds?

Trackers offer a straightforward way to invest. As the name suggests, a tracker fund tracks the performance of any given market. They are low cost and can make an ideal introduction for new investors looking to invest in equities or bonds over the long term.

The key difference between an actively managed fund and a tracker fund is that the tracker manager does not pick the shares or bonds he or she thinks are likely to do well.

Instead, a tracker manager will simply replicate the contents of the index being tracked, say the FTSE 100 if it’s tracking the performance of the top 100 UK shares, or the FTSE All Share if it’s following the whole market.

The active manager on the other hand seeks out shares that he or she thinks will do better than the market index, not match it. The risk is that these bets will not come off and the fund could do worse, or underperform, the index.

Why tracker funds?

Not everyone will want to invest in a tracker. Some people will prefer the idea of doing it themselves or else using a fund manager’s expertise to try to get the highest returns possible.

Nonetheless, as a way of getting exposure to shares or bonds, they are straightforward and relatively low cost as they do not require an expensive team of fund managers to follow what individual companies are doing. Other forms of investment such as managed funds usually require upfront fees from investors, as well as annual charges thereafter.

Trackers, for the most part do not charge to invest, but simply take a small percentage of the value of your investment each year, typically 0.3% to 0.5% annually.

Remember though that trackers are designed to follow a benchmark index and their performance should mirror exactly that of the chosen benchmark, so if the index is rising, the tracker fund will rise too. If it’s falling, the fund value will fall too.

The manager will not intervene to avoid stocks that he thinks are heading for a fall. But that’s not a reason for avoiding trackers, even in bear markets.

Trackers make excellent long-term holdings because shares have risen consistently over the long term and have bounced back strongly from any downturns. Don’t forget also that in a falling market, active funds are just as likely to hold the wrong shares and fall in line with the index.

Their higher charges won’t help either and will make the performance figures look even worse. And when the market is rising, with a tracker you need have no fears that your manager is invested in all the wrong shares and that you’ll miss on the growth.

How do tracker funds work?

A tracker fund works by attempting to match as closely as possible the make-up of the index it is tracking. That might suggest all funds following one particular index should be homogenous, but that is not the case.

The performance of tracker funds varies considerably, dependent not only on what index the fund is following, but also on how the fund is invested.

There are three main ways in which tracker funds can replicate an index.

The first is full replication where the manager buys every stock in the index in proportion to its weight in the index. For example if Vodafone’s market value is 10% of the FTSE 100 index, a tracker using this method would have 10% of the fund invested in Vodafone shares.

This is suitable when the underlying stocks are easy to buy and sell and the numbers involved are not too great. Many FTSE 100 trackers use full replication. The disadvantage is that dealing costs can be high to match exactly index weightings.

A second method is the sampling technique where the manager will buy the biggest shares in the index and then stock up on bellwether shares instead of every share in a particular sector.

Bellwether shares are leading shares – they may be the biggest constituent of a sector – and what happens to them tends to reflect the performance of the whole sector.

Another common strategy to achieve replication is to use derivatives. The manager will use cash flowing in to buy options, which will produce the same result as the index being tracked.

Each of these replication methods can cause what is known as tracking error. This is where there is a difference between the performance of the fund and the performance of the index. Sometimes the underperformance can be as great as 14%.

High initial charges can also add to tracking error. As investor you should be aware of this and check the historical performance of the particular tracker fund and provider you are looking to invest in.

How to choose a tracker fund

The most important thing to consider when choosing a tracker fund is which index you wish to track. You may feel fairly certain that the UK market will continue on its upwards trend for a while yet and decide to invest in a FTSE 100 or an All Share tracker.

Or perhaps you already have a lot of exposure to the UK through other holdings, in which case you might decide to track the US market. No one, though, can predict which index will perform the best, and consequently diversifying your investment to include both home indexes such as the FTSE All-Share as well as other international indices is a sound ploy.

Other things to consider are charges and tracking error. Most trackers do not apply an initial charge, or only a small fee, and annual fees should also be reasonable.

You should compare the costs of similar funds and examine tracking errors to make sure your fund is a top performer in these respects. While the fees may be lower for tracker funds, they are still an issue when it comes to choosing which tracker to invest in.

One point of caution is that trackers following the more familiar indices tend to be cheaper, whereas the more obscure an index, the higher the charges are likely to be. How much can you invest There is no limit to how much you can invest in a tracker fund.

For new investors, trackers make great foundations to an equity portfolio so if you are just starting out, or only have small amounts to invest, you don’t need to worry yet about diversification. How much you invest will depend on how much you can spare.

Most funds make it easy to invest small amounts each month or you can invest a lump sum. As time goes by, or if you have extra cash to invest, you might consider allocating money to higher risk investments, say specialist funds, such as a small companies unit trust or a biotech fund.

If you investing inside an individual savings account limits will apply. Currently, the limits are £11,520 in total in a stocks and shares ISA each tax year.

There is generally no limit on how much one can invest in a tracker fund, however spreading the risk of any portfolio is sensible. If you have already invested in a tracker that follows a London index, then diversifying to follow indices abroad spreads the risk in your investments.

How long do I invest for?

There is no hard and fast rule about how long you should stay invested. Many people invest because they have a particular aim. They may be investing for their children’s university education or wedding or their first house.

They leave their money invested for as long as possible and then later, as they approach the time when they will need the money, they switch their investment into cash or bonds to protect gains that have built up.

You are free of course to cash in your holdings at any time although you may lose money if your timing coincides with a market downturn.

The most important thing when putting money into the stock market is to invest for the long term (ie at least five years) as this will help you avoid the short term peaks and troughs.

Putting a Tracker in an ISA

ISAs allow your investments to grow free of capital gains tax. You can shelter your tracker fund in an ISA usually at no extra cost. Over time your investment should grow in value and when you cash it in, you will not be liable to pay any capital gains tax on your profits, however large they may be.