Tracker funds are a type of investment product that follows the performance of a market index, for example, the FTSE 100.
Table of contents
If the index performs well, the tracker fund value increases, but it also drops if the index falls.
The benefit is a tracker fund is relatively low-cost and a stable investment that usually pays out dividends.
While the stocks held in a fund allow for strong diversification, the downside is that the returns available are relatively modest.
Many people and organisations invest in tracker funds as an alternative pension product and a minimal risk investment spread over various assets and places.
Tracker Funds vs Index Funds
Tracker and index funds are two sides of the same coin named because every stock market is based around an index. The FTSE All-Share, for example, represents the businesses worth the most listed on The London Stock Exchange.
In the US, the major indices include:
- The S&P 500, measuring the stock value of the 500 largest US corporations on the New York Stock Exchange
- The Dow Jones Industrial Average uses price-weighted Indices to measure movements in the leading industrial companies.
- The Nasdaq Composite, tracing stocks listed on the Nasdaq Stock Exchange.
Comparable Indices in the UK are the FTSE 100, FTSE 250, FTSE 350 and FTSE All-Share.
Indices are groups of stocks and shares collated by a fund manager, so overall performance depends on the aggregate results of everything tracked.
Managing a Tracker Fund
A tracker fund commands a passive management approach – if you invest in a fund, you’re buying a representative sample of all the shares included in the index.
The fund doesn’t work like an active investment, where you make decisions to try and out-perform the market, but reflects current market conditions, and so is lower cost to manage.
One caveat is that if the index falls, there isn’t much you can do about it.
A diversified index is better than one dominated by a particular corporation or business sector.
That is what happened in the 2008 banking crisis – most of the FTSE 100 stocks were banking institutions, so a collapse in the financial sector directly impacted all tracker fund values.
Understanding How Tracker Funds Work
These passive investments replicate the performance of the relevant index in two main ways:
- Full replication means that the fund buys every component within the index. That could mean purchasing shares in all of the 100 companies on the FTSE 100, proportionate to the size of each enterprise.
- Partial replication is often used if it isn’t possible to buy all of the indexed shares, so the fund invests in a sample, which is seen as a good illustration of the index as a whole.
The MSCI World Index is an example of a partially replicated tracker fund – the index includes over 1,600 enterprises across 23 different countries.
It would be complex and costly to invest in shares across this volume of businesses, so the fund uses partial replication to achieve a good sample.
Tracker Fund Investment Costs
The nature of a tracker fund means that the management costs usually are much lower than any actively managed investment product.
Many investors purchase tracker funds independently since they won’t require a fund manager to monitor performance continually or offer advice.
In comparison:
- A tracker fund can cost from 0.1 per cent of the fund value on average.
- Actively managed investments normally cost from 0.5 to 1.5 per cent.
Although the investment management cost differential isn’t enormous, it can considerably improve overall profitability.
Exchange-Traded Funds and Tracker Funds
Exchange-traded funds (or ETFs) are tracker funds listed on the stock exchange, so they can be sold or bought at any time when the market is open.
The primary difference between an index fund and an ETF is that the ETF is traded on the stock market so that prices can fluctuate each day.
Given that these products are usually part of a long-term investment strategy, minor market movements are not a cause for concern.
Investors opt for ETFs as they have higher liquidity, so it’s easy to move money into or out of the fund, making an ETF a more flexible and transparent investment option.
However, some ETFs require active management, which means that the management costs will probably be higher.
Traded ETFs also carry stock exchange fees, which can add up over time.
There are various ETFs, tracking bonds, commodities and sectors, enabling investors to add industries and markets to their portfolios that are unavailable through other channels.
Still, an ETF tracking a specific sector usually is more volatile than a tracker fund linked to a broader index.
Get Investment Advice from the Experts.
Choosing the Right Tracker Fund Investment Approach
Tracker funds are highly versatile, and there are numerous ways to diversify an investment portfolio across different asset classes, business sectors and countries.
There are two core ways to receive an income from a tracker fund, choosing either an income fund or an accumulation fund.
Accumulation means that any gains are reinvested into the fund, whereas income is paid in cash.
Analysing Tracking Error Records
If you’re unsure how to pick a tracker fund, the best method is to look at how well the fund has tracked the index – deviations in performance mean the fund isn’t reliable.
A tracker fund can’t match the index exactly, in part because annual management fees will be deducted, but if the tracking error is zero per cent, it means the fund is replicating the index perfectly.
If the tracking error equals the account fees, the investor has an excellent investment and a high-performance tracker fund.
ETFs tend to have lower error records than unit trusts, and a synthetic ETF also performs well, but the pitfall is an element of higher risk.
Synthetic Exchange Traded Funds
A synthetic ETF is a fund that doesn’t purchase shares or actual commodities but synthesises that structure by making agreements with another party, like an investment bank.
The ETF swaps the performance of the selection of investments for returns that precisely match the tracked market or commodity.
There are higher risks with a derivatives contract, including the potential failure of the bank that would likely mean losing the investment.
Many ETFs are not covered by the UK Financial Services Compensation Scheme, as they aren’t domestic to the UK, so analysing that risk exposure is essential before making any decisions.
All You Need to Know About Tracker Funds FAQ
Is a tracker fund the same as an index fund?
Index funds are another name for tracker funds and are designed to provide an investment opportunity to get involved with the breadth of an index at a low cost.
Funds trying to match the performance of the specific index in question are structured as an ETF or an alternative investment.
Index funds aspire to track the market rather than beat it – therefore, risks are lower, but returns are more modest.
Where can I invest in a tracker fund?
Some tracker funds allow direct investment, although most people purchase tracker funds through an investment brokerage or online platform.
The advantage of a platform is that you can invest through multiple assets, including ISAs, which mitigates tax exposure and can provide additional benefits.
Investors can also purchase tracker funds through a self-invested personal pension scheme (SIPP).
What’s better – a managed fund or a tracker fund?
Much depends on how much you have to invest, your risk exposure expectations, and the returns you anticipate making from your investment.
For example, suppose you’re looking for a long-term investment with stable returns and low risk.
In that case, a tracker fund may be a suitable product, working similarly to a typical pension fund or with a self-managed pension pot.
Actively managed funds are more expensive than a tracker fund because you’ll need an account manager or financial adviser to try to outperform the market.
The risk is that your managed fund is more likely to suffer losses.
Still, the benefit is that you can receive returns far above those of the index provided you are proactive about analysing market conditions.
Is a tracker fund a passive investment?
Index and tracker funds are not actively managed and follow the performance of stocks or shares within the index.
Can I have multiple tracker funds?
You can. Every tracker fund or ETF tends to invest in at least 20 or 30 stocks, and sometimes more. Investors with multiple tracker funds will hold shares in possibly thousands of listed businesses, so there is a lot of potential for diversification across a massive range of stocks.
Related Information
Below is a list of related articles you may find of interest.
