What are the benefits & risks of tracker funds?

Advocates of index tracker funds argue their simplicity and low costs provide the best exposure to the stock market.

However, some investors believe a carefully selected, well-diversified portfolio of actively managed funds is likely to produce the best long-term returns because a good fund manager can outperform the index. Some investors will consider holding both types of fund.

Benefits of index tracker funds

• Low charges
  As there is no research team to pay, there are usually no initial charges and annual management charges are low - typically between 0.25% and 1%.
• Exposure to the index
  Tracker funds aim to offer exposure to an index, so performance is easy to follow.
• Low management risk
  The potential for an actively managed fund to outperform its benchmark index rests with the skill of the fund manager, which means they can also underperform. A tracker fund isn't actively managed so there is less risk of deviating significantly from market performance. However most tracker funds will slightly underperform each year because of the effect of the fund's charges.

Risks of index tracker funds

• Stock/sector specific risk
  Although a tracker aims to hold all the stocks within an index, it also holds them in the same or similar proportions, which can increase company and sector specific risk.

  For example, in the late 1990s Vodafone represented 15% of the FTSE 100 Index, creating a large stock specific risk. In addition, various sectors have dominated the make up of the FTSE in recent years; banking, telecoms, oil and pharmaceutical are generally the biggest. A tracker fund has no choice but to invest in these sectors in the same proportion as the index, regardless of the prospects or valuation.

• No fund manager discretion
  Tracker funds do not have the flexibility to avoid shares, sectors or industries going through a difficult period. For example, in 2008 many active fund managers reduced their exposure to banks when the financial crisis hit, which helped them to avoid the worst falls in the stock market. Tracker funds had to maintain their exposure to banks and therefore the associated falls.
• Tracking error
  No tracker fund will ever perfectly replicate the performance of an index. Attempting to replicate the market is essentially chasing a moving target. The best tracker funds will aim to minimise any tracking error, but even a small divergence each year can result in quite different performance from the index over the long term.

If you have a question about index tracker funds please call the Helpdesk on 0117 314 1795.