Trackers are good if they are cheap. But any widely diversified fund is just as good

'Trackers' are low-cost funds that aim to replicate a particular stock market index. The overwhelming body of evidence is that the majority of funds fail to beat their benchmarks over the long term. This fact has supported the headlong growth in popularity of trackers.

Any snags?
Nevertheless, it's not all roses. There are technical problems in tracking an index.

Stocks have to be bought and sold as they move in and out of the index. Relative balances between stocks must be periodically adjusted to match the index. And all this has to go on at the same time as every other tracker is trying to do the same. This is difficult, and therefore can be expensive.

How does this show up?
The difference between the performance of a tracker and its index is called tracking error. Trackers are sometimes categorised as 'good' or 'bad' depending on the size of this tracking error.

But what merit is there in tracking an index? There's nothing magic about an index. It's just the sum of a lot of parts added together in a particular way. The primary merit of a tracker is that it invests in a wide range of stocks and therefore achieves the magic of diversification at low cost.

But that can be achieved just as easily (and maybe should be) by picking the same number of stocks with a pin. Certainly one could argue that the risk profile of any UK tracker could be improved by reducing the index weighting of some of the shares at the top. BP, Vodaphone, HSBC and Glaxo comprise 25% of the FTSE100, and the oils and miners represent another 25%. So if you track the FTSE100 (or the FTSE AllShare which is dominated by the FTSE100) you've got half your investment in this narrow group. Worth thinking about.

And the lesson is....?
Don't worry about tracking error. Just pick a widely diversified fund with low fees. Even better, consider saving the fees entirely by building your own diversified portfolio. If necessary pick stocks at random within classes that give good diversification through independence.

One warning
Avoid like the plague a dangerous beast sometimes called a 'closet-tracker'. These are funds that pretend to be actively-managed, and charge the fees to prove it, but are actually stuffed with all the same stocks as everybody else. They are easy to spot. They will charge annual fees of 1.25/1.5% and their investment objectives will be generically boring.