How to choose a tracker fund

The decision to buy a tracker fund is anything but passive, says John Stepek. Here are the key questions to ask before investing.


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"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 funddo 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.

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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.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.