Cashing in with tracker funds

Millions of pounds have been ploughed into tracker funds over the past six months as investors attempt to cash in on the stock market recovery. Almost £260m of new money was invested in trackers during the second quarter of this year, according to figures compiled by the Investment Management Association. But, despite their popularity, many investors could actually be better off in actively-managed funds.

The increasing current popularity of tracker funds, whose aim is to mimic the actions of a particular index, such as the FTSE 100 or FTSE All-Share, is mainly due to people's desire to replicate recent market gains within their own portfolios without having to take the risk of choosing particular shares, funds, or sectors of funds.

In the last six months or so, with stock markets recovering from their slump of 2008, trackers have replicated that recovery and consequently have proved safe bets, and therefore can look an attractive option.

Their apparent simplicity and the relatively low costs involved are also seen as key reasons why these funds have staged a return to prominence, according to Geoff Penrice, an independent financial adviser at Honister Partners.

"Another positive is that most actively-managed funds end up performing worse than the index," he says. "Therefore, if you can track the index at a lower cost, then you are likely to outperform 75 per cent of such portfolios," he explains.

Many trackers performed very well as the UK stock market enjoyed a turnaround in fortunes over the summer months. As the FTSE 100 rose substantially from its low in March, trackers following it enjoyed a similar uptick.

In fact the best performers – which include the Prudential UK Index Tracker Trust and the Scottish Widows UK Tracker – have achieved returns higher than 20 per cent over the past three months, according to Lipper figures.

However, such positive figures don't impress Mark Dampier, head of research at Hargreaves Lansdown, who points out that it is hardly surprising that funds whose sole purpose is to track a particular index will enjoy a good run in a rising market.

He warns that although trackers are cheaper to buy and manage than active funds, investors could still feel the effects of both costs and errors in the index tracking.

"These funds may track the index, but there will be a cost involved and that means they will also underperform," he said. "If you look at trackers over a 10-year period you will see they are often quite a few per cent behind the individual index."

Although trackers have lower charges, some funds and managers are capable of consistently outperforming the markets and this can make a huge difference over time, said Geoff Penrice.

"Trackers can't take a defensive stance either," he adds. "When markets are expected to fall, active fund managers have the ability to move into cash or more defensive assets, but that is not the case with trackers which will simply have to follow their chosen index, in whichever direction it is heading."

For example, the Prudential Managed Funds Tracker Trust has delivered a solid 15.11 per cent over the year to September 30, according to Lipper, but this is dwarfed by the 52.26 per cent return achieved by the actively-managed SVM UK Opportunities fund.

The differences are even more marked when you look at longer periods. The best FTSE 100 trackers have returned just under 40 per cent over the past five years – less than half of the figure achieved by the top less restricted funds in the UK All Companies sector.

However, not every active fund has done so well.

In fact, while the poorest performing trackers have still returned more than 20 per cent since the end of September 2004, the actively-managed funds at the bottom of the sector have made double figure losses over the same period.

So how can people decide which route to take? Well, before they can choose, investors need to have a grasp of how these schemes actually work, appreciate the risks involved, and then decide on which index they are planning to follow.

Tracker funds have been popular since they first started to appear two decades ago, with UK investors now having almost £21.5bn invested in them, which accounts for about five per cent of total funds under management.

The aim of the funds is to replicate a particular index so they will go up in line with any increases their benchmark enjoys, but fall in value should it take a turn for the worse – as was the case before the most recent stock market rally.

Although there are now trackers of some description following virtually every index around the world, UK investors are most likely to consider those that track a prominent index in this country, such as the well-known bluechip FTSE 100.

The fund manager will simply buy the stocks in the same proportions as they appear in the index, although different methods, such as full replication and sampling, may be used, says Andy Gadd, head of research at Lighthouse Group.

"The funds are typically run by computer model so all the fund management decisions are taken out of the equation," he said. "Performance can't be affected by the subjective decisions of a fund manager."

This is in stark contrast to so-called active funds whose managers have greater scope to buy and sell stocks; the idea being that the most highly-skilled have a better chance of finding companies that can beat market expectations.

It's also wrong to view index tracking as a totally safe option. Not only are they inextricably linked with the fortunes of whatever index they are following, their performance may also vary depending on how they mimic the index.

Trackers can also suffer disproportionately if dominant sectors in an index suffer. For example, when the banking and oil areas go through difficult times this can have an adverse effect on funds tracking the bluechip FTSE 100 which contains a lot of them.

But although trackers are regularly touted as the perfect way for newcomers to take their first steps into equity markets, they are also worth considering by other investors, suggests Andy Gadd at Lighthouse Group.

"Even more experienced individuals can benefit from having a tracker as part of their core portfolio for one simple reason: cost," he says. "They are one of the cheapest ways of gaining access to the markets."

Of course, some funds don't fit neatly within active or passive definitions. Some active managers can only move slightly away from their benchmark index which effectively makes them quasi-trackers – even though investors may still pay them a hefty annual management fee for their trouble.

For those that like the idea of trackers, they can be purchased in a variety of ways, says Geoff Penrice at Honister Partners, such as unit trusts or OEICs, ISAs, and through investment bonds or pension schemes.

"We have also seen a large increase in the choice and use of exchange traded funds (ETFs)," he adds. "These are a cheap, liquid and transparent way of investing in asset classes or mirroring a market without having the cost of actually buying the asset."

ETFs are open-ended index funds that are listed and traded on exchanges in a similar way to stocks. They generally track the performance of a particular index or sector and can give investors access to a wide variety of exposures.

There is a huge choice of ETFs, for example iShares offers more than 390, which can be linked to virtually anything from the FTSE to property, as well as commodities such as oil and gold.

Tracker or active funds: It's your choice

For people who want to invest in the stock market but are not sure which shares or sectors to back, a tracker fund can be a good compromise. Because trackers closely mirror the movements of a major stock market index, such as the blue chip FTSE 100, then returns can be less volatile than investing directly in one company, or even a group of companies through a sector fund. This is because even if one share – or sector – slumps, the index – and therefore the tracker fund – should be saved from slumping by other better-performing shares.

But, by the same token, anyone who feels knowledgeable enough to carry out their own research into different funds and fund managers, stands a greater chance of making better returns by embracing a more active style. If they pick the right fund, then returns can outstrip the index, which can be dragged down by poor performers.

Geoff Penrice at the independent financial advisers, Honister Partners, believes it all comes down to portfolio construction. In many instances, there will be room for both approaches within the same overall investment portfolio, he says.

"I would suggest that most investors should consider using a mix of both active and passive investments," he says. "Passives should be at the core of their portfolio and they should then use satellite actively-managed funds to try and deliver above average returns."

But it depends on the individual knowledge and the time investors can devote to their investments, says Mark Dampier at Hargreaves Lansdown. "An awful lot of people buy trackers simply because they haven't got time to follow markets closely," he says.

"When you invest in active funds it's because you are usually backing the manager. So if you haven't got the resources to keep monitoring the performance of different fund managers, then that does tend to push you more towards the passive side."

However, a major plus point for passive fund management is the cost. As trackers don't regularly trade shares they have lower fees, sometimes as low as 0.3 per cent, whereas active funds often levy five per cent initially and then 1.5 per cent annually.