3 reasons NOT to invest in an index tracker

I know, I know. Those of you who know me in person will probably be spluttering into your coffee.

Three reasons NOT to buy an index tracker? By Malcolm Wheatley, a self-acknowledged 'index tracker bore'? Who must have written possibly hundreds of articles on buying index trackers, many of them here on The Motley Fool..?

I know, I know. But nevertheless, there ARE reasons for not buying an index tracker. Perfectly valid reasons, too - and today I'm going to explain them.

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I hold trackers

First, let me say at the outset that the majority of my own holdings are in index trackers, in the form of both tracker funds and ETFs. So if you - like me - hold trackers, then I'm definitely not urging you to sell them.

Second, let me also add that I agree 100% with smart investors such as Warren Buffett, who has repeatedly urged retail investors - that's you and me - towards investments in trackers.

Here he is in 1996, for instance:

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

Simple and straightforward

And his views haven't changed since. A couple of years back, aware that he is in his mid-80s, and likely to be outlived by his long-term partner Astrid Menks, Buffett left very explicit instructions as to how investments held in trust for her after his death were to be managed:

"My advice to the trustee could not be more simple," he wrote to Berkshire Hathaway shareholders. "Put 10% of the cash in short-term government bonds, and 90% in a very low-cost S&P 500 index fund."

But even with the endorsement of Warren Buffett, that doesn't make an index tracker a perfect investment. As with most things, a set of - admittedly attractive - positives come with a few niggling negatives.

Let's take a look.

Do you want the whole market?

First, think about what an index tracker is actually is: it's a basket of all the shares in a given index - the FTSE 100, FTSE 250, or FTSE All-Share, for instance.

Which is great if you actually want to own a stake in all those businesses. But not so hot if you don't.

Because, as we all know, it's not too difficult to run your eye down a list of shares and see companies that you wouldn't want to buy.

But like it or not, buy a tracker, and that's what you're doing.

Higher-income alternatives

Second, an index might contain shares that you want to buy more of than the proportion of the index that they represent. This is particularly true of income investors.

At the time of writing, the FTSE 100 yields 3.6%. But there are shares within that index that offer much higher yields.

Earlier this month, for instance, I topped up my holding of Legal & General, which currently trades on a forward yield of 6.8%. That's 90% more income than the index offers.

Writ large, that's what equity income investing is all about: pretty much all of my own income-delivering purchases have been bought on forward yields that were 50% higher than the index's average yield.

And a similar argument can be made for growth shares, of course. If you're a growth investor, you will want to position your portfolio towards higher-growth shares, rather than the lumbering giants of the upper end of the FTSE 100.

Trackers are not cost-free

Thirdly and finally, index trackers come at a price. Admittedly, there has been a huge revolution in recent years: ten years ago, when I started writing for the Motley Fool, charges of around 0.5% were considered a bargain.

Now, some brokers offer trackers with charges that are almost a tenth of that: a fees war, begun by Vanguard and HSBC, has slashed costs to a fraction of the rates that were prevailing a decade back.

Even so, however small, a fee is a fee. Hold individual shares, and become your own investment manager - with no holding fees to pay, especially if you choose to hold them in an ordinary brokerage account, rather than a tax-advantaged wrapper such as an ISA or SIPP.

Granted, you will have incurred purchasing costs. But so you do in a tracker, where they are bundled in to the fees.

But on a large portfolio, held for the long term (and especially if you're an income investor, or want to avoid particular shares or sectors), the cost gap closes.

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Malcolm owns shares in Legal & General and HSBC. The Motley Fool has recommended shares in HSBC.