Index tracking funds exploded in popularity in the 1990s when a handful of firms began offering these products, which have been used by professional money managers for decades, to small investors.
In the second half of the 1990s, it seemed to many investors that they had found the holy grail - investment funds that were low-cost and never underperformed, or at least only marginally. These funds were index trackers whose sole aim was to replicate the performance of stock market indices such as the FTSE 100, rather than having managers to pick portfolios of stocks that might - or might not - outperform those indices.
But then came the 2000-03 bear market, which sent trackers tumbling. Now the debate about active versus passive funds has been re-ignited by the recent recovery in larger company shares, particularly those of the oil giants. So is it time for investors to turn to trackers again?
When they first appeared, trackers seemed like the answer to many investors' prayers. They did away with one of the hardest parts of investing - choosing the right fund manager. During the 1990s, trackers became increasingly popular as the FTSE 100 index raced ahead leaving many active managers behind, but when the downturn in the stock market began in 2000, the index trackers nose-dived too. This gave active managers their chance to shine. Though they couldn't buck the general trend of the market, they could choose companies with more defensive qualities. Managers of UK equity income funds, for example, came into their own during this period, as they naturally tend towards companies with strong cashflows.
Since the stock market started recovering in March 2003, the performance of index trackers has picked up again. Indeed, it is in strongly rising markets that trackers are normally expected to do particularly well. Yet on this occasion, it was the actively managed funds that led the way. This was mainly due to the fact that the shares of smaller and medium-sized companies, which had become particularly undervalued during the downturn, recovered fastest. Good active managers were able to increase their weightings in these companies and take advantage of this trend. Most tracker funds, on the other hand, have an in-built bias towards larger companies.
Their success is based on the idea that they get round the perceived drawback of traditional actively managed funds. Traditional fund managers buy shares in companies that they hope will beat the relevant index, such as the FTSE 100 or the All-Share. In other words, they aim to achieve returns better than the wider stock market. However, in doing so, the majority pick the wrong stocks and their fund then underperforms the market.
Trackers do something very different. They attempt to track the performance of the index itself, rather than set out to beat it. This is because they believe that in the end, no traditional manager manages to do better than the index for very long, and if that is so, it makes more sense to literally track the index. How they do this differs between funds. Some trackers buy shares in all the companies that make up the index. Others use complex financial instruments to track what the index does by buying shares in a cross-section of companies. This is why the perfomance of, say, a UK FTSE All-share tracker fund can differ slightly between providers. Note that trackers, like all unit trusts, can only invest up to 10% of their portfolio in one listed company's stock to ensure that the investor's risk remains adequately spread.
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Minimum: Usually £1,000. £2,500 Gartmore UK Index.
Maximum: Phone deals of £15,000 or more per trust may be delayed until the next valuation.
Money back: A few days at the market price. You can usually buy and sell by phone.
Interest Variable: Called distribution. The before tax interest is called yield. Trusts which track overseas markets tend to have a very low yield or none at all. These trusts don't claim to track the yield of the respective indices, only capital growth. You can expect the yield of the trust to be somewhat lower than the yield of the index which is being tracked because of the yearly charges which are made by the trust.
Interest paid: Usually yearly or half-yearly by cheque to you or direct to a bank account. Some trusts have accumulation units which accumulate income; with others your income can automatically buy extra units (at a charge).
Comparing trackers and fees: Check here, just click the Charges button, upper left.
This is a controversial question. The evidence so far is that trackers are providing a good deal for their clients. When markets rise they are among the best performers. But when a bear market begins to bite, trackers slip down the fund performance league tables. However, even in this case, they still do less badly than many of the large popular funds favoured by small investors.
The main benefit is the cost. Since tracker firms do not need to have expensive teams of experts who need to follow what individual companies are doing, they are cheap to run. They are cheaper still because they do not have the costs involved in buying and selling different shares on a regular basis. As a result, the costs of investing are lower. A traditional unit trust or Oeic might charge you 5% up front and then 1.5% of the fund's value each year. Most tracker funds do not charge anything up front and just 0.5 to 1% a year. This is good news: with a traditional fund, your money has to grow by 5% in the first year just to put you back where you started.
Some people believe that tracking an index results in imbalance; for example, around 40% of the FTSE 100 Index is made up of banks and other financial shares. If this sector should go through a bad patch, the index would suffer accordingly. A traditional fund manager who saw this coming might have been able to sell some of these shares and buy other ones instead. A tracking fund cannot do this, it must hold shares in the companies that make up the index. Someone who bought a worldwide index in 1990, for example, would have had around 45% of their money in the Japanese stock market, and got slaughtered in the great Tokyo meltdown.
The industry likes to keep quiet about the fact that financial institutions invest a far greater proportion of their money in trackers than small investors. Not least because if the tracking philosophy is correct, then the entire investment management industry is redundant - including its highly paid experts. Many financial advisers simply cannot believe that a well-run fund will not do better than the index over the medium term.
It is a fact that the majority of fund managers never do better than the index, which is a key selling point for the trackers. But advisers believe that good fund managers do outperform. Finding such a fund is a job for experts, however, which is why you probably need an independent financial adviser if you want to invest in a managed fund. For tracker funds, it's more or less a case of choosing a fund with the lowest charges.
As with any investment strategy, you should adopt the safety-first philosophy: do not put all of your eggs in one basket. The low charges and simplicity of a tracker fund make it an ideal core holding in your portfolio. You can then use more traditional funds to build on that base. Also, shop around. Annual charges on UK trackers vary from 0.25% up to an extortionate 1.5%. Some firms even have the temerity to add on an initial charge of up to 5%.
Trackers are far more effective in 'efficient' markets, such as the UK and the US. For instance, in those countries, financial systems ensure that everything investors need to know is in the public domain and well reported. Therefore, it is harder for a fund manager to seek out bargain stocks that have been overlooked and he or she will struggle to beat the index.
But in less efficient markets, such as countries in the Far East, stock-pickers find it easier hunt out gems and therefore find it easier to beat trackers.
It can make good sense to use a tracker fund as an additional part of your pension provision - even as an alternative to a personal pension. The reason is that with a pension, much of the first few years' contributions will be wiped out by hefty front-loaded charges. So if you need to stop paying contributions because, say, you move to a new job with a company scheme, the low charges on your tracker fund will leave you with more of a nest egg for the future. You can also continue paying into the tracker over the long term. As ever, if in doubt, take expert advice.
This bias varies somewhat from market to market and fund to fund. The main UK, German and French stock market indices all tend to be top-heavy, with just ten companies making up around 40 per cent, 55 per cent and 60 per cent respectively of the FTSE All-Share, HDAX and CAC 40. The problem is less acute in the US and Japan, where the top ten companies account for some 20 per cent of the S&P Composite and 30 per cent of the Nikkei 225.
With those UK trackers focusing on the FTSE 100, the index for the UK's top 100 companies, the emphasis on larger companies is obvious. But even in the FTSE All-Share index, which covers 700 companies, the 100 largest companies make up over 80 per cent of the index by value, mid caps 13 per cent and small caps only 4 per cent.
The FTSE All-Share has become progressively more concentrated in recent years, says James Dalby, head of investment strategy at advisory firm Bates Investment Services. "Tracker funds are not the diversified, low-risk option that many people think they are," says Dalby. "Ten years ago the top ten UK companies accounted for just 23 per cent of the FTSE All-Share; now they amount to over 40 per cent."
This growing concentration was highlighted in July when the oil company Shell decided to have its full listing in the UK rather than dividing it between the UK and Holland. This more than doubled its weighting in the FTSE All-Share index to around 8 per cent, making it second only in size to BP. In response to this trend, a new series of indices had been launched in June by FTSE International, capping company weightings at 5 per cent. But critics felt this would have only a marginal effect on concentration.
It is not only the domination of a relatively small number of companies that is seen as a potential problem - it's also the concentration on a limited number of sectors. Although there are 30 industrial sectors represented in the FTSE All-Share, almost 50 per cent of the index is concentrated in only five sectors: oil, banks, pharmaceuticals, mining and telecoms. When one of these sectors is doing well, the index will too, but any one sector can also hold it back.
"The strong oil price this year has had a positive effect on tracker fund performance because it has boosted the oil companies," says Tim Cockerill, head of research at financial advisers Rowan plc. "As long as the oil price remains high, this benefit will continue. But if the situation changed and the oil price fell it could be a drag on performance as it represents such a large part of the index. So the risks for investors are quite high."
But supporters of index trackers argue that the risks posed by concentration can be overstated. Richard Wadsworth of financial advisers Fitzallan Ltd feels that trackers may not be as diversified as some actively managed funds and they may be dominated by large companies, but these companies have usually become large for good reason. "Actively managed funds have other risks associated with them," says Wadsworth.
And Scott Mowbray at Virgin Money, which has one of the largest UK index-tracking funds, points out that many large companies are global businesses, which provides a different sort of diversification.
It is undeniable, however, that returns on UK tracker funds have become much more dependent on the performance of the largest companies. And in recent months, as signs emerged that these companies were becoming popular with investors again after two years of outperformance by small and medium-sized companies, statistics suggest tracker funds are once again pulling ahead of many actively managed funds. Over the past year, for example, fewer than 10 per cent of active managers in the All Companies sector have beaten the All-Share Index.
Over longer terms many active managers are also currently failing to deliver, says Mike Connolly of Legal & General, which has a range of both UK and overseas trackers. "Despite what people say about actively managed funds performing better than trackers during market downturns, our research shows that over the five-year period to the end of June 2005, which included three years of market falls, 71 per cent of UK actively managed funds failed to outperform our UK Index fund," he says.
Most UK funds track the FTSE All-Share Index, but a growing number of funds are now tracking the FTSE 100, which generally mirrors the fortunes of the top 100 blue chip companies. A small number of funds track mid-ranged companies - the 250 largest quoted companies after the top 100.
FTSE 100 trackers are already becoming more volatile as new technology companies enter the index. These have become top 100 companies due to demand for their shares rather than increasing revenue and profits, and are not considered blue chip companies. As trackers have to buy them, their prices may become even more inflated - possibly leading to price corrections in the future.
FTSE 100 and FTSE All-Share trackers are also concentrating investors' money in just a few shares. Mergers and share price rises mean that recently enlarged companies now dominate these indices.
Generally European index trackers are designed to track the FT/S&P World Europe excluding UK index, which comprises the shares of Europe's largest companies listed on 15* different stock markets (*Source: Financial Times). European investments can seem more speculative, but trackers are pitched lower down the risk scale.
US trackers either track the FT/S&P World USA index or the S&P 500 Composite index, so they spread their investments across a broad range of US shares.
Far Eastern trackers include Japanese funds tracking the FT/S&P World Japan index or the Nikkei 225 index, and Far Eastern funds tracking the FT/S&P World Pacific excluding Japan index.
International trackers track either the FT/S&P World excluding UK index or the new FTSE Global 100 index.
Technology trackers are new funds that invest in the shares of Internet, e-commerce and other hi-tech companies.
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