What is a tracker fund?
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.
Video: how do tracker funds work?
Find out what tracker funds are and how they work in our short video below.
Why are they also called 'index' funds?
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 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.
Find out more: Dividends can play a powerful role in generating an income from a stock market fund. Use our dividend tax calculator to find out how much you'll pay in 2017-18.
How do trackers track?
There are two primary ways that passive investment funds mimic the performance of an index.
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.
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.
How do I know what makes a good tracker fund?
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 that 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 trusts 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 that 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.