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Best tracker funds for your Isa

Created:

23 February 2009

Written by:

Maike Currie

Ten years ago, Richard Branson created some clever PR around his newly launched Virgin FTSE All-Share tracker fund, by placing a bet with a SocGen (SG) fund manager that his tracker would outperform the manager's UK growth fund over a three-year period. Three years after the much-publicised duel, Mr Branson was forced to eat humble pie. The SG fund had returned 19.2 per cent, compared with Virgin's paltry 9.9 per cent.

But today, the tables have turned - the Virgin All-Share tracker has outperformed the UK growth fund since launch. Reason enough to add tracker funds to your individual savings account (Isa) portfolio? Possibly, although some argue that exchange-traded funds (ETFs) could do the same job - but cheaper.

Set up as collective investment vehicles, tracker funds are constructed to follow the performance of a specific stock market or sector. These index-linked funds attempt to do this through a number of different methods, be it full replication, stratified sampling or optimisation.

With full replication, the manager buys every stock in the index in appropriate proportions. Many FTSE 100 tracker funds use full replication.

Under the stratified sampling approach, the manager buys the biggest stocks in each sector and then a sample of the other stocks, while a manager using the optimisation method will use statistical analysis of historical share price performance.

Andy Gadd, head of research at independent financial adviser (IFA) Lighthouse Group, explains that when selecting a tracker fund for your Isa the choice of developed market indices can be huge. "When looking for a 'target index' a decision must be made as to what actually constitutes the US equity market for example," he explains. "One might use the Dow Jones Industrial Average, the S&P 500, the Russell 3000 or the Wilshire 5000. The Wilshire 5000 is generally recognised as the best overall barometer of the US equity market as it contains approximately 98 per cent of all US-headquartered equity securities, while an index such as the S&P 500 is, by definition, overweight in the biggest securities within the market."

Tracking error

Equally important to understanding the make-up of the target index is knowledge of how the tracker fund itself is constructed, as this can directly impact the fund's tracking error. Tracking error is the difference between the performance of the fund and the performance of the index, and is an important indicator of whether the fund is sticking to its remit.

Mr Gadd says that with sampling and optimisation techniques there is more of a chance that tracking errors will occur if past behaviour proves to be a poor predictor of future behaviour. Tracking error risk is minimised with a fully replicated fund.

"While all indexed funds will have some tracking error, it is the level of this error that should concern investors as it is a clear indicator of the accuracy of the fund's investment approach," he says. "A high tracking error can potentially have a greater effect than the highest annual management charge."

"Tracking error can also work both ways. An investor should be wary of a tracker that has moved to the top of the performance tables, since this could imply a level of tracking error as great, or even greater, than the bottom fund.

But tracking error figures, while important, need to be treated with care. "The problem is that different management groups value their funds at different times of the day," says Mr Gadd. "In the course of a day, the market can move significantly and this can have a huge effect on tracking error figures.

"Investors also need to be wary of tracking errors over cumulative periods of time. Two index trackers may appear to have a similar tracking error over a five-year period but one may have closely and consistently tracked the index month on month, quarter by quarter and year by year, whereas the other may have experienced wild positive and negative swings but ended up in the same place. It is therefore worth looking at tracking error figures over a variety of time periods."

Costs should be rock-bottom

Another core consideration when it comes to tracker funds is cost, which impacts on performance. But costs can vary considerably.

According to Martin Bamford, joint managing director of Surrey-based IFA Informed Choice, although trackers do not typically charge you an initial fee to invest, the annual management charges tend to range from 0.3 per cent to 0.8 per cent. A tracker fund that charged a 2 per cent initial fee and an annual charge of 0.5 per cent would underperform its index by 4 per cent over five years.

Adrian Lowcock, senior investment adviser at IFA Bestinvest, likes Fidelity and L&G's tracker funds. Total expense ratios for Fidelity's tracker funds are set at 0.6 per cent, while L&G's tracker funds charge 1.0 per cent.

Tim Collyer, head of investment solutions at Falcon Group, points out that some of the best performing tracker funds are held by the high street banks - for example, the Santander 100 Stock Market Tracker, Royal Bank of Scotland FTSE 4 Good Tracker and the Halifax FTSE All Share Tracker funds. "The banks clearly have a requirement for simple products because of their client base and therefore tend to do a slightly better job at trackers," he says.

ETFs - the new way to track

An alternative to trackers could be found more cheaply in the exchange-traded funds (ETFs) space.

Essentially baskets of securities that are traded like individual stocks on an exchange, ETFs have no entry or exit fees and usually have annual fees of less than 0.5 per cent. However, comparing the Halifax and Santander trackers to their ETF counterparts, it is clear that ETFs are not always cheaper. While the Halifax FTSE All Share Tracker, with its total expense ratio of 1.5 per cent, is much pricier than the Lyxor ETF FTSE All Share's 0.35 per cent, the Santander 100 Stock Market Tracker's total charge of 0.35 per cent is cheaper than its UBS-ETF FTSE 100 counterpart, which has a total expense ratio of 0.6 per cent.

That said, the Halifax tracker did a better job of replicating the performance of the index, given its one-year tracking error of 1.99 per cent, compared with Lyxor's 3.89 per cent. However, db x-trackers ETF FTSE All-Share did the best job of the three FTSE All-Share trackers, given its one-year tracking error of 0.2 per cent. While both the UBS-ETF FTSE 100 and the Santander 100 Stock Market Tracker had a high tracking error over one year, UBS's 1.63 per cent was slightly better than Santander's 2.01 per cent.

Ron Hudson, managing director of Chartwell Direct, a direct-to-client investment service, prefers an ETF over a standard tracker fund. "Why should you pay in the region of 1 per cent in annual management charges for a tracker to almost certainly underperform the market, even when the product's tracking is 100 per cent accurate?

"ETFs have lower charges and their structure means they offer a much better replication of the market. They are liquid and offer exposure not just to the various stock market indices, but also to the various asset classes."

Mr Lowcock sees ETFs as a good means of accessing direct assets. "One of the big advantages of ETFs is holding investments that involve physical assets such as gold or oil. You do not want to try to buy these outright yourself and ETFs provide a good way of minimising the costs involved with getting access to these investments."

See our free investment guide to ETFs - and our interview with Manooj Mistry, head of ETF provider db-x

Active or passive?

As tracker funds by their definition follow a chosen index or benchmark, Mr Bamford says these investment vehicles work best in a rising market. He adds that index tracker funds are also preferred in volatile investment markets, if you are investing money on a regular basis.

Mr Lowcock agrees that in times of high volatility and a lack of clarity in the market - which has been the environment for the past 18 months - trackers are generally better investment vehicles than actively managed funds. He explains: "Active managers were caught out by the banking collapse, whereas a tracker fund would not have been overweight or incorrectly positioned in any particular area because it would be rebalanced by the movements of the index itself."

He adds that, because trackers follow a specific index, they tend to be weighted heavily towards large-cap companies and, in a recessionary environment, tracker funds benefit from their exposure to companies that have stronger balance sheets and are thus better positioned to outperform during downturns.

However, there are those who argue the very opposite. "There is a view that tracker funds are more volatile than active funds as they are fully invested - they go further on the ups but also further on the downs," says Mr Gadd. "That said, trackers may be a good entry point for certain investors."

A popular way to utilise tracker funds in your Isa is the so-called 'core and satellite' approach, which involves a core tracker fund holding complemented by an active fund satellite that you hope will outperform the index. "This approach - where active and passive happily co-exist - represents for appropriate investors the best of both worlds," says Mr Gadd.

An interesting point is made by Glyn Williams, investment analyst at MAC Financial Advice, who says that too many people focus on the UK equity active versus tracker debate, but where trackers really start to score is overseas and in obscure markets - the latter applying especially to ETFs.

"You can also use sector ETFs - both long and short - to adjust your market exposure," he says. "For example, run a straightforward equity index fund plus a short banks ETF and a long healthcare ETF for defensive times and then simply switch to long and short, respectively, in healthier times."

How trackers compare

Notes: Figures to 16 February 2009. Calculations based on an initial £100 lump sum on a bid-bid basis. Source: Morningstar

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