Funds - To Track or to Manage?

Posted on: 25 October 2010 by Mark O'haire

One question asked by many investors is this: 'Do I invest in a tracker fund or a fund that is actively managed?'. Peter McGahan explains the pros and cons.

Many people, of course, believe that their pension funds, endowments and bonds are already actively managed on a day to day basis. They often turn out to be mistaken - and badly.

By and large most of the larger managed funds simply spread their capital across a wide range of sectors and then leave it to 'ferment'.

This is easy money for them, but many investors don't react so well to their overall poor performance. Yet it is often only after a period of constant under-performance that investors finally decide to hold their adviser to task.

But what is a tracker and how useful are they?

The idea of a tracker is to reduce costs by simply allowing your fund to follow a given stock market index, as opposed to having a fund manager trying to beat it.

Of course the PR companies of those in favour or against this regularly come up with arguments that I could easily hit with a nine iron, and yet they both have a point.

It's not that difficult to look at a graph of 'actively managed' fund managers to see that most are just large, expensive clumpy tracker funds with the speed and agility of the Titanic just before it hit that iceberg. Their fees are extortionate despite their under-performance and they are no doubt aware that the reputations of their companies' brands let them get away with it.

However, some managers add value on a day-to-day basis and if you analyse this over time, rather than via a snap shot at a high or low point in their history, you will see the numbers adding value are small but consistent. That said, a good quality investment adviser will have the processes in place to pick the very best. However, if you are considering a tracker fund, you might just need to do a bit of homework, as all is not what it seems.

After all, there are two main types of trackers: Full Replication trackers and, wait for it, Stratified Sampling trackers. Great eh? Full Replication means your tracker will do everything it can to track a given index - such as the FTSE 100 - by buying, where possible, the same stocks in a similar weighting to that of the actual index itself.

Stratified sampling, meanwhile, isn’t as sexy as it sounds - it's just over-complicated - but let me explain. This version of a tracker holds the biggest shares of the index plus a sample of the other leading shares from that sector. So, whereas an index might hold twelve pharmaceutical stocks, the Stratified Sampling tracker might hold the top five or six pharmaceutical stocks instead.

If I am deciding which is the best tracker, I simply analyse those tracker funds that are big enough to trust and study how much they track the index and how much they differ from it. Then I simply look at the charges, as all else is secondary with a tracker.

As such, it really is hard to imagine why a tracker fund could actually charge more than a 1% annual total expense ratio, and in fact, you might expect this to be closer to 0.5% than 1%, whereas an actively managed fund could be over 2%.

A Total Expense Ratio (TER) is simply a measure of the total annual costs of running a fund and includes the costs for other services paid for by the fund, such as the fees paid to the trustee (or depositary), the custodian, auditors and registrar.

Some TER's are c0.3% and are a very attractive way to access the market but be careful as they don’t all do what they say on the tin. Be sure, in any case, to do your homework.

Need Expert Advice?

Peter McGahanPeter McGahan is an Independent Financial Adviser and Managing Director of Worldwide Financial Planning. Worldwide has won 16 Financial Times awards in the last four years. Peter has also been named the top media IFA of the year by in 2009.

Peter comments regularly in major journals such as the Mail on Sunday, Irish News and Sunday Times and is a weekly columnist for FT Adviser. He has also appeared on Working Lunch and the Today programme. In addition he is an expert on international tax matters for a range of international publications.

Worldwide Financial Planning Ltd are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'

Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.

If you have a financial query you would like Worldwide Financial Planning to respond to, call 0845 230 9876 or email [email protected]

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