How to choose a tracker fund

“Passive” investing is a misnomer. Passive funds or exchange-traded funds (ETFs) charge a low fee to track an underlying benchmark, as opposed to active funds, which charge a high fee to try to beat a benchmark. But the decision to buy a tracker is anything but passive. Here are the key questions to ask before investing.

What does a tracker fund do and why buy it?

The most important thing with any fund is to understand what it does. What index or price does it claim to track; what exactly is in that index; and what role would it play in your portfolio? For example, there are many increasingly exotic trackers – “smart beta” ones that follow specific strategies; “themed” ETFs tracking individual sectors; or “leveraged” ETFs that promise double or treble an index’s daily returns. If you plan to invest in one of these, you have to ensure that you understand what it does.

Yet even apparently straightforward trackers can trip you up. Say you want to own South Korean stocks. The iShares MSCI South Korea Capped ETF is an obvious choice. Yet the underlying index is dominated by electronics giant Samsung. You might like Samsung, and you might be happy to buy an ETF that has more than 20% of its funds in that one stock. But you certainly need to be aware of that fact before you invest.

What’s the tracking error?

A fund’s annual fee matters, but the “tracking error” – that is, the gap between the performance of the fund and the index itself – matters even more. Bloomberg’s Eric Balchunas notes that while passive funds are rules-based, they aren’t run by robots – there’s still a human portfolio manager, and a good one can minimise tracking error by, for example, lending shares to investors who want to short-sell a stock in exchange for a fee. Balchunas highlights the Vanguard Total Stock Market Index fund. It charges just 0.05% a year, yet has a tracking error – after fees – of just 0.01%. In other words, the manager has managed to make back most of his annual fee for the fund’s investors.

How liquid is the fund?

Liquidity is all about how easy a fund is to buy or sell. ETFs, which are listed on a stock exchange, offer the ability to buy or sell at any point in the trading day. The risk is that if the ETF is invested in illiquid underlying securities – or securities that will become illiquid if the market crashes – then the ETF price might depart from the price of its portfolio in a collapse. This doesn’t necessarily mean avoiding potentially illiquid ETFs – but be aware of the issue, consider if an ETF is the best way to buy, and don’t invest in illiquid securities if you think you’ll need the cash in a hurry.