Three tracker pitfalls to avoid

Passive funds that track an index or asset are simple and cheap. Yet some funds track better than others. So how do you know which fund to buy? Tim Bennett explains.

Passive funds that track an index or an underlying asset, such as gold, have two major benefits they are simple to understand and they are cheap compared to active funds. What's more, if you buy them in the form of an exchange-traded fund, they have another benefit over the many unit trusts (passive or active), which is that you can buy or sell them at any time.

However, all is not equal in the world of the tracker fund. Some track better than others. Here's a summary of the key pitfalls to avoid when choosing one.

Not all tracking funds do what you might expect. It's important to know exactly which index a fund is set up to replicate. Even then, watch out, as many index-tracking funds do not hold all of the underlying constituents of an index, just some or most of them.

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And some funds don't hold the underlying asset at all commodity funds may achieve their exposure via the derivatives market rather than a physical holding.

Any of these pitfalls can lead to tracking errors. For example, HSBC's Pacific Index Tracking Fund underperformed its benchmark by 58% over the last ten years, according to fund research group Lipper, quoted in the Financial Times.

Meanwhile, the Ignis Japan Tracker Fund turned in 28% less than the FTSE World Japan Index, and the Scottish Widows Overseas Fixed Interest Tracker underperformed the JP Morgan Global Bond Traded Index by 21%.

It's also worth noting that many standard index trackers are market capitalisation weighted. This means that the fund will tend to hold a greater percentage of a popular stock based on its higher market capitalisation. Equally, as a once-popular stock falls, a passive fund will dump it. Some critics accuse passive funds of forcing investors to buy high and sell low.

One thing's for sure you won't beat the index with a passive fund. But at least you'll be getting your exposure cheaply. According to Bestinvest, in developed markets such as Britain and America, more expensive active fund managers have struggled to beat their benchmarks over three years.

Finally, don't be tempted by funds that use words such as inverse or leveraged, unless you have read the literature carefully. The way these products are re-priced on a daily basis means that their performance can be tricky to predict. Since most are neither simple nor cheap, they're best left alone by most investors.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.