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