Different types of investment Understanding tracker funds and ETFs

Dice - buy or sell

Trackers and ETFs are low cost alternatives to actively managed funds

One of the simplest ways to get started with investment funds is through a tracker. These are low cost collective investment schemes that just follow the movement of an index. 

So when an index rises, the value of your fund rises with it (after costs). Conversely, when the index falls, your investment in the fund falls with it too. Trackers are known as passive investments because your fund manager isn't making any 'active' decisions about markets or individual investments.

Tracker funds - what are they?

An index is made up of a number of stocks and shares - it goes up if the aggregate performance of those shares is up and vice versa. 

There is at least one index for each stock market. For example, the FTSE 100 is an index that represents the biggest 100 UK companies, and the FTSE All-Share represents all the UK companies listed on the London Stock Exchange. More obscure indices, made up of bonds or commodities, also exist and can be accessed by investors.

Changes in the shares’ value are averaged to create the index. This gives a picture of how the overall market has changed. Tracker funds give you immediate access to the entire range of companies or bonds in an index. 

And because they require no management in terms of choosing shares - most just buy all the shares in the index - tracker funds are much cheaper than actively managed funds.

One potential downside downside of passive investing is that, if an index is dominated by a particular type of company or sector and it takes a tumble, your investment will fall with it.

This happened during the banking crisis in 2008, when the FTSE 100 and many other indices were dominated by banks. An actively managed fund has the ability to move money tactically to avoid sectors that the manager thinks are overvalued.

How do trackers and ETFs track?

There are two primary ways that passive investment funds mimic the performance of an index:

Full replication

This is the process of buying all components of an index. For example, a FTSE 100 tracker fund will buy shares in all 100 companies in the index, in proportion to size of the companies within the index. This means that funds can mirror the performance of the index as closely as possible.

Partial replication

When it is difficult to buy all the shares in an index, some passive funds invest in a sample of an index that is generally representative of the whole index. A good example of this is the MSCI World index. This comprises more than 1,700 companies from 23 countries - the time and cost it would take to hold all the companies in the index for full replication could be detrimental to the portfolio.

Instead, partially replicated passive funds will purchase a sample of the companies that are most representative of the index itself. 

What are ETFs?

Tracker funds have traditionally come in the form of unit trusts and Oeics but these are limited in the number of indices that they can track. Exchange traded funds (ETFs) are a newer innovation in the investment industry.

Like unit trusts and Oeics, they are open-ended, meaning that you can buy or sell in and out of them at any point and their price directly reflects the underlying value of the investments they hold.

The difference is that they are listed on a stock exchange, like shares, and can be traded at any time that the market is open.

Therefore, they can be more transparent, liquid (meaning you can move money in and out of them easily) and flexible than unit trusts and Oeics.

The emergence of ETFs has enabled investors to get access to markets and assets previously unavailable. ETFs can track almost any stock market index all of over the world but also the price of commodities, like gold, oil, natural gas and even lean hogs. These types of ETFs are known as exchange traded commodities (ETCs).

Synthetic ETFs

Some ETFs physically invest - they buy the underlying securities in an index and that’s how they will track. Some ETCs buy the underlying commodity, like gold, and just track the price.

But what about when you want to track a market that’s not as easy to get access to? Or a commodity, like oil, that’s prohibitively expensive to buy and store? This is where synthetic ETFs come into play.

Instead of buying the underlying shares, bonds, or commodities in an index, the ETF will enter into an agreement with a third party investment bank (a counterparty) to swap the performance of a basket of investments in exchange for the exact return of the stock market or commodity it’s tracking. This is a type of derivative contract.

There are extra risks that come with this. If the third party investment bank were to fail, some of the investment could be lost. Under regulations, synthetic ETFs are only allowed 10% exposure to a counterparty, meaning that the value of the basket of investments needs to be equivalent of 90% of the value of your investment. Some ETFs now hold over 100% in collateral (full protection against the event of the counterparty failure) to lessen this risk.

It is important to note that many ETFs and ETCs aren’t domiciled in the UK. Therefore, they are not subject to the Financial Services Compensation Scheme (FSCS).

How can you judge passive performance?

The best way to judge the performance of a passive investment fund is to look at its tracking error. This shows how far the fund’s performance deviates from the actual index it’s tracking. Of course, no tracker fund will identically match an index as an annual fee is levied on the funds. A tracking error of 0% would mean perfect replication. A tracking error which is just the cost of the fund is an indicator of an excellent passive investment.

ETFs generally have a better tracking error record than tracker unit trust and Oeics, and synthetic ETFs generally improve on this further. But, as we have explained, these options can come with extra risks that you might not be comfortable taking.

How much do tracker funds cost?

The key attraction with passive investments is their low costs. There are some tracker funds which levy an ongoing charge of less than 0.1%, with most competitively-priced trackers charging less than 0.2%. This compares to a typical ongoing charge for an actively managed unit trust of 0.85%. ETFs typically have ongoing charges of less than 0.5%, with many as low as the cheapest unit trusts. 

But not all trackers are cheap - there are one or two with charges as high as 1%. So never assume that a tracker is automatically cheap - it's still important to check the terms of your chosen fund carefully before investing.

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Last updated:

February 2016

Updated by:

Michael Trudeau

 

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