An easy and cheap way to invest in the stock market
More and more investors are ditching actively-managed funds in favour of low-cost index trackers.
As the name implies, an index tracker fund replicates the performance of an index, such as the FTSE 100.
As it doesn't require anyone to actively buy and sell stocks, you are charged far lower fees.
And given that the returns often match – or even beat – actively-managed funds, it's not hard to see why they're becoming more popular.
According to the Investment Association trade body, private investors have doubled the amount invested in passive funds over the last 10 years.
More recently, investment firm TD Investing Direct has reported a 36% increase in demand for such funds over the last year alone.
So, if you'd rather not spend endless hours picking your own stocks and shares, read on to fund out more about index trackers.
They're easy to understand
As we mentioned, an index tracking fund replicates the performance of an index by investing in all the shares quoted on it.
For example, a FTSE 100 index tracker should invest in every one of the top 100 UK companies.
This means if the FTSE 100 rises by 5%, the value of your investment will increase accordingly (minus fees and charges, and what's known as tracking error, which we'll explain later). Equally, if the FTSE 100 drops by 5%, your investment will drop by roughly the same amount.
It's as simple as that. All you need to do is decide which index you would like to track. For example, you can stick to the home market if you wish.
If you want an investment that covers the majority of UK listed companies, choose a FTSE All Share tracker – rather than one based on the FTSE 100 – and you'll gain exposure to around 98% of the market.
It's also possible to invest in trackers globally which replicate indices overseas.
Index trackers are 'passively managed' which means there's no fund manager actively picking stocks to invest in, as this decision is completely determined by the companies that come onto the index, or fall off it.
There are different ways of tracking, but commonly the amount invested in each company will equate to the proportion of the index it comprises. In other words, the most money will be invested into the largest companies.
Because there's no active fund manager – the index tracking strategy can be achieved by computer – the fund charges are significantly lower with no investment expertise required. There's a whole raft of tracker funds which charge 0.5% or less.
Remember, any index tracker with a significantly higher charge is effectively ripping you off since all trackers which invest in the same index are essentially doing the same thing. A fund with annual charges of 1% should be considered very expensive.
When you consider charges, the Total Expense Ratio (TER) is the best figure to look at. Sadly it doesn't include all the costs for all funds, but it's the most accurate figure that is easily obtainable.
Index trackers are also great for smaller investors since many funds require a relatively low monthly contribution from you.
If you've got £50 a month available, you should find plenty of trackers which will accept this level of investment. Of course, trackers will accept payments from larger investors too.
They beat many actively managed funds
You might think a passively managed fund couldn't possibly perform as well as a fund with an active fund manager. But you'd be wrong. Picking the right stocks is an incredibly difficult task, and even the experts make the wrong calls on a regular basis.
In fact, index tracking funds have been shown to regularly outperform managed funds.
But, don't forget, you can only expect returns which closely match how the stock market is doing as a whole.
A handful of the top performing funds are capable of beating the market, but you will have to pay higher charges for the benefit of the manager's stock picking prowess.
You should also bear in mind that the top funds today may not continue to be the star funds of tomorrow.
But, with an index tracker, you'll have an investment that always generates returns more or less in line with the market.
They won't take up your time
Finally, as you've probably realised by now, you don't need to be an investment whizz to pick a decent index tracker.
Nor do you need to spend your precious time seeing how particular sectors or shares are performing before diving in. All this is done for you, making trackers the perfect choice for novice investors.
Tracking error measures how closely the fund moves in line with its underlying index.
So let's say there are two funds that both track the FTSE All-Share index: Fund A and Fund B. Fund A's tracking error is -0.5% while Fund B's tracking error is -1%. That means Fund A grew by 0.5% less than the index while Fund B grew by 1% less.
You may be wondering why the performance of the two funds differ given that they're both tracking the same index.
The difference will probably be explained by differences in the funds' 'tracking strategies'. Some funds buy all the companies in the underlying index while other funds will only buy a selection of the companies.
As a general rule, the funds with the lowest tracking error are the best, so Fund A is the one to go for – all other things being equal.
Accumulation versus income
You'll notice that some funds offer accumulation and income versions.
This is because, in line with the shares on the index they're tracking, funds pay dividends. In simple terms, the accumulation fund reinvests these dividends, while the income fund pays them out, usually twice a year.
Pension and ISA treatment
That way, your investment will grow completely free of both Income and Capital Gains Tax (with the exception of an Income Tax charge for higher- and additional-rate taxpayers on dividends).
These days you can save as much as you'd like into a pension to plan for your retirement (with restrictions in place for higher earners). And you can invest a maximum of £15,240 into a stocks & shares ISA each year.
If you wish, you can hold a tracker alongside other investment funds to diversify your pension or ISA portfolio.
Index trackers can also be held as direct investments outside pensions and ISAs, but then any capital growth earned will be taxable when you take a profit.
How do I choose an index tracker?
That's more of an open-ended question. It depends in part on your attitude to risk and your feelings about the markets or sectors you want to track.
The Investing In Funds website allows you to slice and dice funds to look at past performance.
However, as we always have to say, past performance is no guarantee of future returns. Index trackers should ideally be part of a diversified portfolio that should also include cash and perhaps some exposure to bonds.
Where to buy an index tracker
You can buy an index tracker via an investment platform, or fund supermarket as they're also known, such as Hargreaves Lansdown or BestInvest, directly from the fund provider (though this is usually much more expensive), or a stockbroker, or a bank, or via an independent financial adviser or financial planner.
The investment platform and stockbroker methods are always the cheapest.
In addition to the charges on the index trackers themselves you may also have to pay charges for buying and selling them.
Investment platforms may also charge a range of other fees, from annual management fees to exit fees, so make sure you read the small print before you sign on the dotted line.Compare stocks & shares ISA costs quickly and easily at the loveMONEY.com Investment centre (capital at risk)