Investing for growth: Keep it simple: the attractions of trackers

INDEX-TRACKING funds provide a good first step into shares and are good core holdings of any stock market portfolio. These funds are a type of unit trust, normally, so your money will be pooled together with that of many other investors and used to "buy the market".

By buying every, or virtually every share in a stock market index, such funds aim to mirror the performance of the market. So if the market does well so will the fund, and vice versa.

More than 20 tracker funds are now on offer and most follow either the UK's FT-SE 100 index or the All Share index. The companies making up the FT-SE 100 are the largest quoted in the UK and account for 75 per cent of the stock market by value. Funds tracking this index are offered by Direct Line, River & Mercantile, Fidelity, Legal & General, Equitable Life, Lloyds Bank, Sovereign, Barclays and Govett.

The All Share consists of the FT-SE 100 companies plus hundreds of other medium-sized and smaller companies. Funds tracking it are offered by Legal & General, HSBC, Dresdner RCM, Gartmore, Virgin, Old Mutual, Norwich Union and Morgan Grenfell.

With so many companies in the All Share index, a number of fund managers employ a "stratified sampling" technique. Typically, they will invest in the largest 300 companies and then choose a representative sample from the remaining companies. Legal & General claims that most All Share trackers usually end up with very similar portfolios; its fund invests in 700 of the 900 shares.

Trackers offer a number of attractions. First: simplicity. The investment managers do not employ any special approach to picking shares, simply buying the whole market. Second: risk reduction. Instead of "taking punts" that might turn out bad on parts of the stock market, such as engineering companies, they buy everything and do not stick their head above the parapet. A third attraction is that the risk of getting a particularly bad return is lower.

Steve Abbott, marketing director at Legal & General unit trust managers, says: "Trackers give you the market as a whole, so you don't have to decide which fund manager to put your faith in or which part of the market to put your money in."

"Eliminating the risk of choosing a poor fund manager makes sense," says Jonathan Harbottle, a director at River & Mercantile. "It's a statistical fact that most active [non-tracking] fund managers underperform their benchmark index most of the time, because the market is very efficient and because no one gets it right all the time." This claim is borne out in the performance tables regularly: trackers usually do well.

Tracker funds are also cheap, in part because a fund manager does not have to do any research into individual companies, just buy and sell. Many make no initial charge and the annual fee often is less than 1 per cent, compared with the not untypical 5 per cent initial and 1 per annual management fee on a traditional unit trust.

The cheapest FT-SE 100 trackers are offered by the likes of River & Mercantile and Fidelity, while low-cost All Share trackers are offered by Legal & General, HSBC, Dresdner RCM and Gartmore. There also a few funds on offer that track overseas markets. But these are only likely to appeal to investors who already have their core UK investments in place.

Where trackers can fall down is if the stock market does poorly. "If it heads down then the tracker will mirror this decline whereas with an actively managed fund, the manager can take steps to try to curtail any losses," says Roger Cornick, deputy chairman of Perpetual, a well- known active management company. "When markets fall an active fund manager can go liquid [that is, into cash], avoiding companies he doesn't like. An index tracker has to remain exposed to the market. Actively managed funds are more flexible and suited to all sorts of market conditions. Trackers only shine when the markets rise."

Mr Cornick says investors should choose a fund manager with a good track record to outperform both the stock market generally and tracker funds.

One way to try to outperform the market is to take a core approach, where you use a tracker fund as your main investment to provide wide exposure to the market.

On top of this, you then select actively managed funds to spice things up. This way you get a highly diversified portfolio but with the opportunity to outperform the market, too.