The pros and cons of tracker funds

In the investment world there is a question that always divides opinion: should you opt for passive investment strategies or put your faith - and money - with active fund managers to improve your chances of enjoying decent returns?

There's no easy answer. You can make and lose money with both approaches so what route you decide to take depends on a variety of factors, including how much cash you have to put away, how long you're willing to tie up the money, and your attitude to risk.

The first step is to understand the difference between passive and active investing. A passive strategy involves buying so-called tracker funds that mirror the broad construction - and performance - of specific stockmarket indices, rather than trying to beat them.

Active fund managers, meanwhile, buy stocks they believe will exceed market expectations. In this lesson of the Moneywise Investment School we outline the pros and cons of trackers.

How do trackers work?

Tracker funds have been around for 30 years and there is one following virtually every global stockmarket index these days, although UK investors are more likely to seek replication of either the FTSE 100 index of the largest UK-listed stocks or the wider exposure of the FTSE All-Share.

They are often referred to as 'blood hound funds', meaning they sniff the market all the way up and all the way down again, without intervention by a fund manager. As a result, they score highly for their simplicity and cost-effectiveness.

What are the benefits?

A key argument in favour of trackers is that the vast majority of 'active' managers end up underperforming their chosen index. In some cases this is because they are tempted to improve their chances of success by taking bold sector or company positions when compared with the index.

If they get it right they can earn bumper returns, but if they get it wrong - and this is regularly the case - their investors suffer. But if an investor finds a fund manager who is capable of consistent outperformance they will enjoy significantly better returns.

Fees are one of the main differences between passive and active fund management. As they require less day-to-day management - and do not incur the costs of constantly buying and selling individual shares - trackers have much lower charges.

In fact, most will be free to set up and then usually cost less than 1% each year to manage. This compares with active funds for which investors can pay up to 5% initially, and then an annual charge of at least 1.5%, as well as performance-related fees in some cases.

When you also factor in the uncertainty around global markets you can see why they have been so popular with investors. In fact, net retail sales of tracker funds stood at £1.9 billion in 2011, according to the Investment Management Association, the highest on record and up from £1.7 billion in 2010.

What are the drawbacks?

On the face of it trackers might seem to provide a risk-free investment but that's not the case. They will simply reflect the fortunes of a particular index. Therefore, if you're following the FTSE 100 and it rises sharply then your tracker will benefit. Conversely, it will be hit should the stockmarket fall.

The geographical sector being followed can also result in potential pitfalls. No one can describe following the Japanese Smaller Companies sector as a low-risk investment, for example, so it will depend on where you invest your money.

While passive managers seek to replicate an index, active managers buy stocks they think will do much better than the stockmarket expects over the next few years. In this respect, the latter will have a much greater level of freedom over the shape of their portfolios.

Trackers can also suffer disproportionately if particular sectors that make up a major chunk of the index being followed go through a rough patch. For example, if it has a high allocation towards banks it will run into trouble during a financial crisis.

It's also worth pointing out that trackers can't take a defensive stance in bad times. When markets are expected to fall, active fund managers can usually move into cash or more defensive assets, but that is not the case with trackers, which will have to follow the index.

How can they be used?

For investors who want a cost-effective exposure to the stockmarket and haven't got the time or inclination to research active managers, a tracker fund can be a perfect solution. They will be able to rest easy knowing their investment will, broadly, mirror the performance of a particular index.

However, tracker funds can also be of benefit to more experienced individuals who can have them as the core part of their portfolio, and then buy a number of other 'satellite' funds that can be bought and sold in order to make the most of particular market conditions.

Although a tracker is unlikely to ever be the top performing fund in the sector, the compounded effect of low charges year-on-year gives it a big head start over its actively managed rivals - especially during more volatile periods for markets.

Are there different types of trackers?

The most traditional tracking products are unit trusts, which are straightforward to understand and simple to buy. The amount of competition in the strategies market of late also means that the annual charges on many unit trusts have fallen.

However, there is an alternative in the shape of exchange traded funds (ETFs) which are listed and traded on exchanges in a similar way to stocks. This means they can be bought and sold at any time, with their prices changing in response to market movements.

ETFs provide access to a wider variety of countries, asset classes and styles than normally available via unit trusts. However, investors need to know whether a specific ETF holds the underlying assets or achieves the replication using so-called 'synthetic' strategies (through the use of derivatives).

How do you choose a tracker?

The most important decision to make before buying a tracker is choosing what index you are seeking to replicate. For example, if you want broad exposure to the largest companies listed in the UK in your portfolio then that would lead you to a product that followed the FTSE 100.

Alternatively, you may decide you want to follow the equity markets in the US so buy a tracker that replicates the S&P 500. It all comes down to your specific financial goals and whether the constituents of a particular index will help them be achieved.

Tracker unit trusts can be purchased directly from fund providers or via investment advisers and brokers. Meanwhile, ETFs are available through stockbrokers, with telephone or online dealing usually the cheapest route. You should expect to pay £10 to £15 per trade.

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

I still can't decide. Should I track or not?

There's no doubt that trackers are worthy of consideration for both new and experienced investors. In many cases they will work well as part of an overall portfolio that contains both active and passive investment strategies.

The key factors you need to take into account - and these are the same regardless of the product being considered - are your long-term financial goals, where you want investment exposure, the track record of the fund and the various charges involved.

At the end of the day, every investor must realise that neither active nor passive fund management is a guaranteed route to riches. There are numerous variables in terms of economic factors relating to the global economy and individual companies that will affect your overall level of return.

How the charges compare...

This is the typical total cost and impact on a £10,000 lump sum over 10 years, assuming 7% annual growth before charges.

Active fund:

  • 3% Initial and 1.6% annual charges
  • Example value after 10 years: £16,413


  • 0.3% annual charges
  • Example value after 10 years: £19,127


  • 0.4% annual charges plus £6 stockbroker dealing charge to buy
  • Example value after 10 years: £18,937

Investment trust:

  • 0.3% annual charges, plus £6 stockbroker dealing charge to buy
  • Example value after 10 years: £19,115

Active versus passive performance track records

A detailed analysis of returns achieved by funds in the UK All Companies sector over the past decade illustrates how tracker funds can be both a blessing and a curse.

Of the 167 funds in the sector that have 10-year track records, 30 of them are classified as trackers, according to data compiled for us by Morningstar to 22 August 2012.

Perhaps unsurprisingly, active funds are both the best and worst performers over the period. The Franklin UK Mid Cap fund is the standout performer with a return of 305.49%, while Manek Growth is at the other end of the scale with a loss of 8.13%.

The best tracker over the period is the HSBC FTSE 250 Index Retail, which achieved 173.52% - enough to push it into seventh place overall. This means that it has beaten 131 active funds.

The worst tracker over the past 10 years has been the Family Charities Ethical Trust, which came in at 164th, although it still posted a positive return of 34.93%.