Should you invest in tracker funds?

8 July 2015

This approach sees them buying into so-called tracker funds, whose aim is to mirror the performance of a particular index, rather than trying to beat it.

In fact, their enthusiasm for these solutions has seen sales rocket over the past few years.

There is currently £106.8 billion invested in this area, according to figures compiled by the Investment Association, which equates to a 12.1% share of the industry's total funds under management – up from 9.9% a year ago.

The big advantage of tracker funds is they are usually much cheaper than their active counterparts – and increased industry competition has led to fees falling substantially, points out Patrick Connolly, a certified financial planner with Chase de Vere.

"They provide an ideal solution for long-term investors who don't have the time, inclination or knowledge to regularly review their investment funds," he says. "Most people with a tracker shouldn't go too far wrong."

Another advantage of passives is that many active managers consistently fail to outperform in more efficient markets, particularly large-cap UK and US equities.This is principally because analysts very closely follow companies in these areas, leaving little unexplored areas where good managers can seek value and growth.

The risks

When you factor in that many investment funds are heavily promoted when they are riding high in the performance tables, only to falter over the longer term due to a combination of poor manager decisions and high costs, it's clear that active management comes with risks.

It's a point illustrated by the Spot The Dog report, published by Bestinvest, which names and shames those funds that have consistently and significantly underperformed. The most recent version of the study, published earlier this year, identified 60 such funds.

"This study doesn't make us popular with fund managers but the reality is that most funds fail to beat their benchmarks and there is far too much of people's hard-earned money stagnating in funds with abysmal performance records," said a spokesperson.

For those who like the sound of passive investing, the good news is there will be something to meet their needs, with trackers following virtually every index around the world, although UK investors are most likely to consider those that track a prominent index in this country, such as the blue-chip FTSE 100 or FTSE All-Share.

The fund manager at the helm will buy stocks in the same proportions as they appear in the index, although different methods, such as full replication and sampling, may be used. This means they may be run in different ways, despite having the same objective.

The packed mutual fund arena has also been joined by a dynamic young rival in the shape of Exchange Traded Funds and, even more recently, Exchange Traded Commodities, which have allowed investors to track a host of exciting areas.The result is a lot of choice.

The various benefits make trackers a viable option for buy-and-hold investors who have longer-term horizons, as well as those who want broad exposure to a marketplace and are more in favour of a slow and steady approach.

"They don't want to be regularly reviewing their investment funds and making changes," points out Connolly. "By using a tracker, investors don't need to worry about their manager underperforming significantly or leaving."

However, it is not a guaranteed route to riches. While replicating an index means they will go up in line with increases enjoyed by this benchmark, it also means they will fall in value should it take a turn for the worse.

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 could have an adverse effect on funds tracking the blue-chip FTSE 100 which contains a lot of them.

Also, once charges have been taken into account, most trackers are likely to underperform their benchmarks.This could potentially limit growth potential, particularly when markets are moving sideways or large-cap companies are performing badly.

As an aside, it's worth noting that top active managers can find opportunities in less efficient areas, such as smaller-cap companies or the emerging markets, due to a combination of their own skills and the fact these areas can be overlooked.

As a result, there is an argument that investors may find the best approach is to hold a combination of active and passive investment funds, with trackers forming the core of the portfolio and the active funds acting as satellite holdings around the edges.

A general rule of thumb is that active funds should be held in sectors where the fund manager has a better opportunity to outperform, while passives are best considered where outperformance is much less likely.

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