A good index-tracking fund can and should be one of the core components of any diversified portfolio. But there's a problem with ETFs. They provide a simple, efficient and cheap solution to lots of investment difficulties yet private investors have been slow to buy them. There are several reasons for this including our continued love affair with star fund managers.
But a bigger problem is probably what's been called the 'biscuit tin' problem – defined by one chief executive of an ETF firm as "investors not knowing what the heck our ETF actually tracks. We'd say it tracked the so and so MSCI index and they'd look at us blankly".
This brutal assessment gets to the heart of the problem. To get the best from low-cost trackers, you need to understand what the fund is actually tracking first.
It's all about the index
Indices are not all equal. Track an imperfect index that's poorly constructed, overweight in just a few shares (say banking stocks in 2008) and you'll end up destroying a large chunk of your money despite all the academics' talk about efficient markets and perfectly optimised portfolios. But there is a huge range of major markets that can be tracked using mainstream indices – nearly all the big asset classes and markets boast an index that's become a part of everyday language. In the US, for example, the level of the Dow Jones Industrial Average or the S&P is the subject of intense daily discussion on a number of major news programmes, while here in the UK all the major news organisations talk hourly about the current level of the FTSE 100 index of major London listed blue-chip companies.
The key for investors is to work out which indices – and markets – really matter and then work out how best to invest in these markets. FTSE Group alone calculates more than 120,000 indices.
In many liquid, mature markets index-tracking funds are probably the cheapest and arguably the best way of buying long-term exposure. Remember that an index-tracking fund will only ever buy the most popular stocks that are increasing in value – it's a giant weighing machine that is heavily influenced by momentum, so if a market and thus an index is overweight popular mining stocks, expect the ETF to be equally overweight.
