Trackers are losers - go for ETFs instead

With most actively managed funds failing to beat the market, investors have welcomed tracker funds. But there's a much easier way to track the markets of your choice: ETFs. We pick the best tracker replacements.

It's no secret that most fund managers don't do a very good job. All one really expects from a managed fund is that it makes returns better than the market as a whole.

But most managers just can't seem to do it: a recent study from independent financial adviser Bestinvest shows that, in the past 20 years, only 42% of actively managed funds beat the market over each three-year period. No wonder private investors have so warmly embraced tracker funds.

The idea is simple. If you can't beat the market, you might as well just replicate its performance, which is what tracker funds set out to do. Sounds easy, doesn't it? But even this task appears to be beyond some providers.

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Popular tracker funds, such as those offered by Virgin and HSBC, have failed in their objective to match their benchmark indices over the last ten years. HSBC's £438m FTSE 100 Tracker has undershot the blue-chip index by 36 percentage points. Virgin has returned just 87.7% against the 117% rise in the FTSE All-Share Index. Investors' loyalty has long been "misplaced", says Paul Farrow in The Sunday Telegraph, and "they are losing out on thousands of pounds because of it".

Why have these funds underperformed so badly? One of the main reasons is annual fees. The higher the charge, the greater the impact on returns. Virgin's tracker charges investors 1% a year huge by tracker-fund standards.

The tracking method used also accounts for some of the difference in returns between trackers. Some buy every stock in the index, copying the weightings exactly. But others use sampling' they buy the biggest stocks in each sector, then a sample of the others. The sector weightings are the same as the index, but the proportion of each stock held is not.

Paul Farrow's solution is to "opt for the cheapest" among others, he recommends Hargreaves Lansdown's All Share tracker, charging 0.25% a year.

But there is a much better and easier way for investors to track the markets of their choice. Exchange traded funds (ETFs) are baskets of stocks that track markets and sectors, but are traded on the market like a share, making them more flexible than buying into a fund. And the charges are cheap too, typically less than 0.5% a year.

There are around 350 ETFs listed around the world, but for those interested in replacing their UK trackers, there is the iShares FTSE 100 (ISF), charging a 0.35% annual fee, and the iShares FTSE UK Dividend Plus (IUKD), on 0.4%, which is designed to track the 50 highest-yielding shares in the FTSE 350. For more information, go to iShares.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.