What is an index tracker fund?

An index tracker fund (also known as a passive fund) aims to track the performance of a particular index; such as the FTSE 100 or the FTSE All Share in the UK. They offer a convenient way to gain exposure to a broad range of shares at a low cost.

The theory is simple; a fund tracking the FTSE 100 should have 100 holdings in the same proportions as the index. So if a company accounts for 5% of the FTSE 100 Index (by market size), funds tracking the FTSE 100 will also invest 5% in that company.

However, investors should be aware that in practice it isn't quite so simple. There are three methods of tracking an index - full, partial or synthetic replication - each has strengths and weaknesses.

Full, partial and synthetic replication

The difference between full and partial replication is quite simply whether the tracker fund invests in all the companies within the relevant index or not.

For example: If a FTSE 100 Index tracker fund used full replication it would own every single stock in the FTSE 100 Index at all times. However, if it used partial replication it would omit some of the underlying stocks (usually some of the smaller companies in the index), generally to save costs and try to maintain a low tracking error against the performance of the index.

Full replication is more common on an index such as the FTSE 100 because there are only a relatively small number of stocks. A fund is more likely to use partial replication on broader indices with a large number of smaller holdings, because some companies are so small their influence on the index performance is considered negligible.

By using partial replication, a tracker fund aims to deliver the performance of the index without the cost of owning every single stock in the index. By looking at the discrete performance of a tracker fund you can see how well or badly it has tracked the performance of the specific index.

Finally, rather than buying each individual stock in an index, tracker funds can replicate the performance synthetically using derivatives and other financial instruments. A common way of achieving the desired result is to enter into a swap arrangement with an investment bank.

Effectively the tracker fund pays the investment bank to give the fund the return from the index. Synthetic tracker funds will often track the index more closely than a fund which buys and holds shares. They often tend to be cheaper because they incur fewer trading charges. However, they are subject to different risks, particularly counterparty risk.

Counterparty risk

Counterparty risk can manifest itself in many different ways. Essentially, it is the risk an asset that has been lodged with another party can't be recovered.

Synthetically replicated tracker funds rely on the investment bank to provide the swap to deliver the return to match the index. Money has been paid to that investment bank to deliver the return. If that bank defaults the fund will not get the return of the index, and may also lose the money paid to the bank. Collateral may be given by the bank to provide surety for the fund and try and reduce the risk.

Rebalancing

Most indices are rebalanced quarterly, with new entrants and leavers. Therefore a fund aiming to track that index should rebalance at least as often as the index does.

When a company comes into an index there could be a large demand for the shares, causing a price spike. As a result, some tracker funds try to buy into companies before they come into the index or sell before they are due to leave.

Stock lending

Some funds can lend the stock held by the fund to a third party, such as a hedge fund, in exchange for a fee. Tracker funds are ideally suited to this because there is often a low turnover of the underlying companies (particularly the larger companies) within the fund. In exchange for lending out the stock a fee is paid to the fund which is generally shared between the fund and the fund manager.

At all times the fund remains the beneficial owner of the shares and is entitled to all dividends. Usually the fund lending the stock still owns it and can recall it at any stage. However there is a small possibility that stock lent can't be recovered, and if that happened the fund would lose money.

Tracking error and how to judge it

Tracking error is a statistical measure of how closely a fund matches the performance of a specific index. It effectively shows the deviation in performance of a fund from the performance of the index. Many funds actually quote a tracking error figure. A simpler way of looking at how well or badly a tracker fund tracks the index, is to look at performance relative to the index.

If a tracker fund underperforms the index one year and outperforms the next, or deviates from the return by more than a tiny percentage, it may not be doing its job effectively.

Tracker funds will generally slightly underperform an index because of the effect of the fund's charges. Even if the underlying investments track the market accurately, any charges whatsoever will reduce the return investors receive. Therefore, if you are considering a tracker fund, you should keep your fund management costs to a minimum.

One point to note when looking at the performance of a fund against the index is the fund's valuation point. Many funds value daily at midday, but performance figures quoted for an index are based on the value at the end of the day. This may lead to comparison of performance over different time periods which can make the tracking error appear slightly greater.