Hunting for The Law of One Price

Classic economic theory says that in an efficient market, competition should ensure the prices of commodities converge on one another, so there is little or no difference in what consumers pay. This is the so-called Law of One Price.

Classic economic theory says that in an efficient market, competition should ensure the prices of commodities converge on one another, so there is little or no difference in what consumers pay. This is the so-called Law of One Price.

Index funds are the nearest we have to a commodity in equity investment, so a check on how well they shape seems a good idea. The first report of Standard & Poor's Fund Research on tracker funds gives us a useful opportunity.

The emergence of a ratings system for tracker funds is a positive development. One of the continuing frustrations for investors has been the difficulty of finding a single source of information that summarises the important features of the 50 or so funds on offer in an accessible and robust way.

With luck, the S&P Fund Research ratings will become the first step down that path. But Fund Research rates only funds which subscribe to its service, and the most notable absentee is Virgin's UK Tracker Fund, the largest in the retail market, with £2.1bn invested.

The survey rates funds on the three main criteria that matter most when choosing a tracker fund. They are: one, tracking error (how closely the fund mirrors the performance of the index it is trying to emulate); two, annual running costs (where the survey correctly uses total expense ratio data rather than the often misleading annual management charge quoted by the fund management company); and three, the bid/offer spread, which is the upfront cost of entering the fund as an investor. As a rule, the best tracking funds are those that cost the least and track their index most efficiently (that is, with a low tracking error).

As a commodity, the performance figures of the index funds should not come into play as a factor in their own right. If you own a tracker fund that deviates significantly from its benchmark index, it is not doing the job for which you bought it. There are variations in the way index funds are managed and priced. The most obvious distinction between tracker funds is which index the manager is trying to track. Tracking the FTSE 100 index, with its 100 component companies, is a different proposition than tracking the All-Share index with its 800-odd companies.

All FTSE 100 funds adopt a policy of full replication, which means buying all 100 shares in the index, but most All-Share funds pursue a partial replication process, to mimic the performance and risk characteristics of the larger index without buying all the component shares (some of which are difficult to buy and sell in volume, because of their small market capitalisations).

But the volatility of the market, which swung from euphoria to relative gloom about technology stocks, has led to unprecedented changes in the the FTSE 100 index. Keeping up with the quarterly changes is costly and tiresome for index fund managers. As a result, the volatility of FTSE 100 share-tracker funds has been higher than that of All-Share tracker funds.

There is no clear pattern in the tracking error between the two segments of the market: for both types of index fund, the reported tracking error ranges from under 0.2 per cent (the best) to a not-so-impressive 1 per cent (or more) in some cases. With tracking error, the figures come from the management company and cannot be estimated accurately by outsiders, because the funds' prices are calculated at a different time of day to the market indices. The picture on costs, which is where the Law of One Price should come in, is also mixed. The Fund Research data, and other professional sources such as Micropal, Lipper and Fitzrovia, reveal striking variations in expense ratios and bid/offer spreads. What's more, some firms use different pricing strategies for different segments of the market; Royal & Sun Alliance charges some investors a bid/offer spread, but not others. Legal & General charges ISA holders a different rate to that it takes from investors who do not use the tax wrapper.

With the annual management charge alone, the range of prices is from 0.25 per cent a year (the cheapest) to (an exceptional and surely indefensible) 2 per cent. Total expense ratios vary just as much, with many funds clustering around 1 per cent per annum (the maximum permitted for a fund to qualify for the Government's CAT standard). With bid/offer spreads, the range is from 6 per cent to nothing, which again is the CAT standard requirement.

The table lists the six funds that achieve Fund Research's highest AA rating and their scores on the relevant measures. Of other funds not covered by the survey, one or two might also qualify, though those that charge 1 per cent a year (a group that includes Virgin) would not qualify for the top rating, due to their tracking error.

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