IF YOU are looking for a cheap and cheerful way to invest in the stock market, tracker funds may provide the answer.
These funds are simple to understand. They replicate the performance of a stock market index so that they go up when the index goes up and down when it goes down. They also benefit from having lower charges than actively managed funds because there is no need to spend money on expensive research or analysis of stocks.
While an active fund will charge as much as 5.25 per cent upfront and 1.5 per cent annually, a typical tracker fund will have little or no initial charge and an annual charge of 0.5 per cent or less.
On top of this, trackers have performed quite well relative to actively managed funds in recent years. Over 2007 no fewer than 34 of the 39 tracker funds are ranked in the top third of their sector. Pride of place goes to Santander’s Stockmarket 100 Tracker Growth fund, which came 17th of 333 funds in its sector, closely followed by trackers from Marks & Spencer, Prudential and Liontrust.
This is quite a surprising achievement when you consider that these funds do no more than buy the relevant index and make no claims to add value by stockpicking.
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It is also something of an indictment of the poor performance of many actively managed funds, which have the freedom to buy and sell stocks as they think fit. With their greater freedom they ought to be able to produce much better returns than trackers, yet a large number have produced lower returns than many trackers, which are shackled to a stock market index.
As John Hatherly, of Seven Investment Management, the wealth manager, says: “The reality is that many so-called active managers do not really engage in active fund management. They run their funds like index funds – in other words they are closet trackers. However, they still charge the higher fees levied by active managers. When you have active funds and trackers doing the same thing – hugging the index – the trackers are going to win out because of their lower charges.”
Darius McDermott, of Chelsea Financial Services, the independent financial adviser, says that another explanation for the recent good performance of trackers is that their greater exposure to large-cap stocks has boosted returns, as blue chips have outshone mid and small-cap stocks. The recent market volatility has reinforced this trend, as investors have sought refuge in the comparative safety of larger companies.
A further point is that the gyrations in share prices provided plenty of scope for active managers to make the wrong choices, while trackers’ obligation to stick with their existing portfolios has shielded them from making similar damaging mistakes.
Jason Hollands, of F&C Investments, which runs the F&C FTSE All Share Tracker fund, says that trackers have a role to play in a balanced portfolio of funds because they offer a cheap and efficient way of gaining exposure to large liquid stocks in markets such as the UK and US, where shares are well researched and most of the information is in the market price. He adds: “They operate in a simple way, rising and falling with the index they track, and since stock markets tend to go up more often than they go down, index funds should rise in value over the long term.”
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Mr Hollands says that trackers also benefit from being required to be fully invested in the stock market at all times. Although this can work against them when markets fall, conversely it means that they capture all of the upward movement when markets rise. Since the prevailing long-term trend is upwards, being fully invested works in favour of trackers.
However, Mr Hatherly points out that while trackers may be cheap and cheerful, they do not provide much exposure to specialist niche areas of the stock market.
He says: “More than 35 per cent of the FTSE 100 index is made up of only six stocks: BP, Royal Dutch Shell A, Royal Dutch Shell B, HSBC, Vodafone and GlaxoSmithKline. If this handful of stocks fails to perform, then your tracker won’t perform.”
Mr Hatherly adds that index funds are also skewed heavily towards certain sectors. Oil, banking and mining stocks make up 44 per cent of the FTSE 100, so investors in tracker funds, far from having a diversified portfolio, are taking heavy bets on certain stocks and sectors.
If, despite these drawbacks, investors think that they would like to put money in an index fund, Mr McDermott recommends that they should first do their research. He says: “Not all funds track the same index. In the UK the majority track either the FTSE 100 or the FTSE all-share. At Chelsea Financial Services, we favour funds that follow the all-share because it gives some exposure to small and mid-cap stocks.”
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He points out that tracker funds also vary considerably in the level of charges they make. For example, Fidelity’s MoneyBuilder UK Index Fund has an annual charge of only 0.1 per cent, while F&C and M&G offer tracker funds with annual charges of 0.3 per cent. In contrast, Virgin’s £2.2 billion UK Index Tracking Trust levies a whopping 1 per cent fee.
Chart-smart
THE chart, left, shows how a typical tracker fund outperformed most actively managed funds last year. For the first half of the year it moved pretty much in step with the average return achieved by funds in the UK all-companies sector, the vast majority of which are actively managed.
But from summer’s stock market turmoil onwards, the tracker fund, like many other tracker funds, moved decisively ahead – an indication not so much that trackers are especially good, but that active funds performed poorly and failed to take advantage of the turbulent market conditions.
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EXPERTS’ PICKS
Darius McDermott gives his vote to Legal & General’s UK Index fund, the biggest in the sector at £4.5 billion, and Fidelity’s Moneybuilder UK Index fund. “Both track the FTSE all-share, our preferred index, and both have reasonable charges,” he says. “The two fund groups have considerable expertise with index funds and we are impressed with how closely they can track a particular index.
“The L&G fund has no initial charge and an annual charge of 0.5 per cent. The Fidelity fund also has no initial charge and an annual charge of only 0.1 per cent.”
John Hatherly likes the look of the M&G Index Tracker Fund. “It has a low tracking error and low charges,” he says. “There is no initial charge and the annual charge is only 0.3 per cent.”
He also gives the thumbs up to Fidelity’s Moneybuilder UK Index fund: “I like it for much the same reasons as the M&G fund – it has a low tracking error and very low charges. On top of that both funds have a good track record.”
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FUND IN FOCUS
The fund: Fidelity Moneybuilder UK Index.
The performance: The fund has lost 3.8 per cent over one year, compared with a loss of 6.6 per cent for UK equity funds as a whole, putting it 123rd of the 366 in its sector. Over five years it stands 97th out of 261, with a return of 103 per cent.
The manager: Riccardo Curcio has 13 years’ experience in portfolio management. He joined Fidelity in 1998 as an analyst and became a fund manager in 2001. He took over the helm of the £543 million index fund in April 2004.
The style: The fund aims to match closely the performance of the FTSE all-share index, with the minimum of tracking error. It holds every stock in the FTSE 100 and FTSE 250 indices, but not all 674 stocks in the FTSE all-share. So one engineering stock may stand proxy for another smaller stock in the same sector, but overall Mr Curcio aims for an accurate reflection of sector, size and style weightings.
Current bets: The biggest sector weightings are currently in financials, cash and oil and gas. The largest individual holdings are in BP, HSBC and Vodafone Group. The decision to hold 20 per cent of the fund in cash is to compensate for buying futures positions in the FTSE all-share index. With futures, investors have to put up only a small percentage of the value of the trade, so to balance out what would otherwise be a highly geared bet, Fidelity keeps the remaining percentage in cash.
The manager says: “My primary concern is simply to track the index as accurately as possible.
“We try to keep our costs as low as possible. We have the financial muscle to obtain the cheapest commission from brokers and to ensure that our trades are done at the keenest rates.
“Although we buy most individual shares in the index, we also use futures purchases as a cheap way of gaining exposure to it without having to buy all 674 stocks every time we invest new money.”
The expert’s view: Philippa Gee, of Torquil Clark, the independent financial adviser, says: “The fund has the lowest annual charge in the business, at 0.1 per cent, and its tracking error is also one of the lowest.
“The fund’s size has helped it to drive down costs through economies of scale and to buy more of the individual stocks in the all-share, thus enabling it to track the index more accurately.”