We've already seen that tracker funds, ETFs and funds of funds can provide low-cost 'bricks' for a lazy portfolio. But you need to be aware of the following caveats.
1. Watch the spread. This is a potentially crucial issue when it comes to buying exchange traded funds that are listed on the stock exchange. They may have low expense ratios but some of the more exotic funds can boast prohibitive bid offer spreads (more than 1 per cent). Frankly any spread above much more than 0.5 per cent should be avoided.
2. Watch the tracking error. Not all tracker funds are created equally. Some investment trust and unit trust trackers following the FTSE 100 and All Share for example have tracking errors – fund return versus index return – that can be more than 1 per cent per annum. ETF providers like Lyxor and Deutsche DBX use a clever technique called synthetic replication that uses derivatives to make sure the tracking error is low although the use of derivatives does mean that the fund is in theory held hostage to any default by the investment bank that issues the ETFs
3. Cut costs in the wrapper and on dealing charges. As we've seen, the very best way of running these portfolios is to invest on a monthly basis, regularly and over a long period of time, preferably in a tax free wrapper that keeps any gains you make away from the tax man. The downside of this approach is that most IFA and fund supermarket driven platforms tend to force you to buy unit trusts and not stock exchange listed products (which trigger dealing charges that can amount to as much as £15 per trade). Also ISA account management fees vary enormously. One interesting alternative comes in the guise of low cost regular share investment plans offered by the likes of HalifaxSharebuilder, Selftrade, and Share Centre. These let you invest in an ISA and buy into listed main market ETFs/investment trusts with very low dealing charges – fees vary from free (for Halifax until June) to £2.50 per trade at The Share Centre.
4. Dividend re-investment really matters. Most mainstream equity index tracking products pay out a dividend – this is valuable even if it's very small and it absolutely needs to be reinvested. According to investment writer Jeremy Siegel "From 1926 through 2004, reinvestment of dividends accounted for 96% of the stock market's total return after inflation." If you are using a monthly, regular investment plan service make sure that these dividends don't just accumulate as cash – if there is an option, make sure that the cash is reinvested quickly into yet more funds and shares
5. Listed funds such as ETFs are now incredibly easy to trade in – you can deal in them, in real time, like any other share. That ease of use encourages many active investors to use ETFs as a short term, trading tools and that can ultimately destroy your capital. According to researchers from Stanford and MIT "the only way to own ETFs that brings you ahead of index mutual funds (unit trust based vehicles that are less accessible in trading terms and not listed on the exchange) is to buy alot of them and hold on to them. Trading ETFs as many do to a fault, will hurt your returns."
6. ETFs are not always the cheapest way of tracking markets. Fidelity's massive Moneybuilder UK tracker fund for instance aims to replicate the returns of the FTSE All Share index and boasts a net effective total expense ratio of 0.10% which is a fraction of the nearest equivalent ETF fund.
7. Its very difficult to capture returns from small caps using index tracking funds. There's no mainstream UK market small cap tracker – there was an investment trust that covered this space but it closed down a few years back. You can capture Euroland and US small cap growth but we're still waiting on someone to develop a proper small cap tracker.
