Investing in Tracker Funds and ETFs

This ‘investing in tracker funds and ETFs’ guide starts with the basics of what index trackers are and expands to explain how to index trackers vary and the best online share dealing platforms to purchase tracker funds and ETFs cost-efficiently.

What are index tracker investments?

Index tracker funds (also known as trackers) and ETFs are investments which attempt to match the performance of a specific investment index. For example, an investment tracker fund or ETF may attempt to match the performance of the FTSE 100, FTSE 250 or S&P 500.

You cannot invest directly into the index itself, so the best way of achieving investment returns which are on par with that index is by making an index tracker investment.

Index tracker investments are passive investment vehicles. This means that, unlike actively managed investment funds where fund managers actively make purchase and sale decisions, index tracker funds/ETFs are largely run by complex computer algorithms which buy/sell shares in an attempt to replicate the index that they are tracking.

What is an investment index?

An investment index is simply a calculated benchmark which is intended to provide a quantifiable measure of the performance of specific stock markets / other asset types. Indices provide a high-level view of how a particular market/asset class is performing.

In the UK, the main stock market indices are as follows:

You will notice that each of the above indices is described as ‘market-weighted’. This is the most common type of stock market index.

Market-weighted indices

Taking the FTSE 100 as an example, this means that the proportion of each company in the index is based on its market capitalisation or total value as a proportion of the total market capitalisation of all companies in the index. This means that Royal Dutch Shell (currently the largest constituent of the index) will have a greater impact on the value of the FTSE 100 index than Easyjet which is far smaller in terms of market capitalisation.

Not all indices are market weighted. Indices can also be 1) unweighted, or 2) price-weighted.

Unweighted indices

Unweighted basically means that each company included within the index comprises an equal share of the index. The FTSE 100 does have an unweighted index – the FTSE 100 Equally Weighted Index – though you will hear this mentioned by the mainstream press far less often. In this index, a relative minnow like EasyJet is given the same as a giant like Royal Dutch Shell.

Price-weighted indices

A price-weighted index is one where the constituent firms are weighted in accordance their price per share, rather than total value. The largest example of a price-weighted index is the Dow Jones Industrial Average (DJIA, or ‘The Dow’) which tracks 30 blue-chip firms which trade on the New York Stock Exchange in the US.

Taking the DOW as an example, the index was initially calculated by simply adding the prices of the Dow component shares and dividing by the number of companies. However, over time this methodology has expanded and the figure used as a divisor has been amended to preserve the historical continuity of the index (e.g. where there have been share splits and mergers). Because of the complexities involved in such a calculation, few market indices are price-weighted.

Which type of stock market index will perform better?

In terms of performance, there is no one ‘better’ type of index. Any of these types of indices could outperform the rest, depending on whether the firms with larger capitalisations outperform the smaller constituents.

Before investing in an index tracker, you should understand both the type of index you are investing in and who the underlying constituents of that index are.

What is in a stock market index?

It’s important to understand both the constituents of the market index and the overall sector exposure. For example, an investment in the FTSE 100 will expose an investor to different segments than an investment in the FTSE 250.

The below charts show the sector exposure of the FTSE 100 and FTSE 250 using ICB Industry classifications and data provided by the FTSE Russell. Data is correct as at 31 March 2020.

The total net market capitalisation of the FTSE 100 is £1.4 trillion compared with just £0.3 trillion for the FTSE 250. The businesses included in the FTSE 100 are typically large international organisations (e.g. oil majors, mining stocks, tobacco giants, pharmaceutical firms and banks) whereas the FTSE 250 firms tend to be more influenced by the UK economy (though many have international operations). The FTSE 250 is dominated by firms in the Financials, Industrials and Consumer Services categories. The high level of Financial firms is explained by the large number of Insurance companies and Investment Trusts included in the index.

FTSE 100 Sector Exposure

[infogram id=”a19ac6db-8ed5-4cf0-9bd4-6a0f8c772e36″ prefix=”d5r” format=”interactive” title=”FTSE 100 Sector Exposure”]

FTSE 250 Sector Exposure

[infogram id=”67ee54fb-a3be-435f-a92e-9d419fc14799″ prefix=”5r4″ format=”interactive” title=”FTSE 250 Sector Exposure”]

What are the different types of index tracker?

Index tracker investments are typically made via ETFs or conventional index funds (unit trusts or OEICs).

Both options have broadly similar risk and return attributes. The key difference is that ETFs are listed on a public stock exchange and so can be bought/sold throughout the day, whereas conventional index funds are priced/traded once a day in the same way that most actively managed funds are.

This increased flexibility and the fact that ETFs tend to be cheaper to acquire has made ETFs increasingly popular with investors over the last few years.

How do index tracker funds / ETFs track the underlying indices?

Investors can choose between ‘physical’ and ‘synthetic’ ETFs and index tracker funds.

A physical tracker fund or ETF holds investments in the underlying stocks of an index. This can be via either full or partial replication. Full replication would involve acquiring shares in all of the constituent companies of an index, whereas partial replication would involve investing in a large enough sample of the companies in the index to represent the whole index. Partial replication would not be used for an index like the FTSE 100, but may be used where an index includes thousands of constituents where it is either difficult to buy (e.g. due to illiquidity) or uneconomical to buy all of the underlying shares.

A synthetic tracker fund or ETF does not physically hold the underlying investments. Instead, its core holdings are swaps which are effectively contracts with counterparties which are akin to IOU arrangements whereby a counterparty (e.g. investment bank) promises to pay the total return of the relevant index as cash. These type of ETFs feature the added risk that the counterparty will be unable to make good on the swap arrangements.

Do index tracker investments vary in terms of their accuracy?

Yes, index trackers experience varying degrees of ‘tracking error’ and ‘tracking difference’. Tracking error is a measure of volatility in the difference of performance between the fund and its index, whereas tracking difference is the discrepancy between ETF performance and index performance. Tracking difference is therefore an easier metric for private investors to consider.

These differences are to be expected given the different approaches to tracking induces mentioned above. Other key factors which may drive tracking errors/differences include fund management and trading fees. Trading fees may rise for example if there are lots of investors moving money in/out or where there are movements in the underlying constituents.

Generally, we should look for tracker funds/ETFs with low tracking errors/differences such that our investment performance closely mirrors the relevant index we want to track. Tracking difference is typically negative as ETFs typically trail the index they are tracking, though not always.

What are the advantages of index tracker investments over actively managed funds?

The key advantage of making index tracker investments versus investing in actively managed funds is cost. After taking the lower fees of index tracker investments into account, very few fund managers will beat the performance of market indices over a 10 year period of time. Even fewer private investors will by picking their own shares because they do not have the same expertise or access to information as the professional fund managers. For a worked example of how much fees can make a difference, check out our ‘investing in shares for long-term growth‘ article.

How much do index tracker investments cost?

As mentioned above, the main advantage of investing in index trackers is cost. If you decide that making an index tracker investment is right for you, you should therefore aim to pick an index tracker fund or ETF which has low ongoing charge figures (OCF) and low tracking differences. The OCF represents a measure of what it costs to invest in the fund or ETF and includes all of the funds operating costs. FTSE 100 index trackers can feature OCF as low as 0.06%.

In addition to the ongoing charge, you should consider platform fees when deciding which online share dealing account to use. See our quick reference comparison table below which illustrates the comparative cost of investing in some of the most popular FTSE 100 and FTSE 250 index trackers across the largest online share dealing platforms.

What is the cheapest way to invest in a FTSE 100 index tracker?

The below tables compare the cheapest way to invest in a FTSE 100 index tracker fund / ETF in a general investment or Stocks and Shares ISA account.

FTSE 100 ETF / Tracker Fund Ongoing Charges

FTSE 100 Tracker Fund Total Cost Including Platform Charges

The four index funds listed above feature an ongoing charge of 0.06%. The below table compares the total annual costs of investing in an index tracker fund across the five largest online share dealing platforms. For smaller investment amounts, Vanguard Investor is the cheapest platform in terms of fees. However, you can only acquire the Vanguard funds via this account. With an investment total of £100,000, it would actually be cheaper to invest in Vanguard funds via Interactive Investor.

As the ongoing charge is the same regardless of which platform you invest with, the fees payable to the share dealing platforms are where savings can be made. With index tracker funds, the account fees payable to the various investment platforms are often higher than when purchasing ETFs. See our cost comparison for FTSE 100 ETF trackers below.

FTSE 100 ETF Total Cost Including Platform Charges

Three of the five platforms shown (Hargreaves Lansdown, Fidelity and AJ Bell YouInvest) feature lower account fees when investing in ETFs instead of index tracker funds. Whilst the cheapest ongoing charge for the ETFs in the list above is 0.07% (0.01% higher than the lowest index tracker fund at 0.06%), the lower account fees more than compensate.

When purchasing ETFs, this means that Hargreaves Lansdown is actually the cheapest provider in our list by far for ongoing fees, despite featuring £11.95 fees per trade executed. When investing in ETFs, you have the added benefit of being able to sell your investment throughout the day rather than on a once daily basis.